- Insider recently hosted a discussion with two investing experts in the stock and bond markets.
- Nancy Davis and Renee Yao broke down the big stories of the past year and shared their outlooks.
- Because of their work, Insider named Davis and Yao to our annual list of the 10 leaders transforming investing.
- Visit Insider’s Transforming Business homepage for more stories.
The year 2021 started out as unpredictable as ever for investors who thought that things might feel more normal after a pandemic-stricken year.
A small group of retail investors captured the world’s attention when they pounced on a handful of stocks that big, institutional investors had been rooting against. After this episode, the broader stock market continued its stunning recovery from last year’s crash as the pace of COVID-19 vaccinations topped expectations. Then out of nowhere, a little-known family office cost some of the largest investment banks several millions of dollars because of its risky bets.
And over in fixed-income land, everyone except the Federal Reserve is seemingly worried that inflation will rear its ugly head.
To help us make sense of these developments, what they mean, and what might happen next, Insider recently tapped two people who we had named as investing industry transformers: Renee Yao, the founder of Neo Ivy Capital; and Nancy Davis, the chief investment officer of Quadratic Asset Management.
The transcript of that roundtable is featured below.
Insider: Thinking about the past year and how it’s really impacted every market, every person, what are some of the biggest shifts that you’ve observed in your part of the industry from a year ago when we were quite literally at the bottom in terms of the sell-off?.
Nancy Davis: I think these moves seemed to be exasperated by very low levels of liquidity. And I think liquidity is still in a pretty fragile state.
I do think the recovery has been absolutely tremendous. It’s a much faster recovery versus, say, the global financial crisis, how quickly we turned around; and how quick and unified policymakers were really around the world on the central bank side; as well as the combination of fiscal spending in the United States. So I definitely applaud the quick action.
But I think the bloom is kind of off the rose in terms of how fragile markets are.
And just thinking about fixed income specifically, that’s definitely something that we saw last year in terms of liquidity and just how fragile the market is, had the Fed not intervened pretty quickly.
The Treasury market was absolutely not functioning normally in March last year. Probably one of the world’s most liquid markets, and even Treasuries became quite dislocated. ETFs really became the source of liquidity. That’s one thing that I’m quite passionate about is the ETF technology is just a wrapper. The underlying asset is what controls liquidity. But many investors were using ETFs because the Treasury market was just not trading, and that’s when you had Treasury ETFs trading at a discount to NAV.
And I think it’s especially timely right now since the SLR extension is not happening and banks will be getting lots of deposits in the coming weeks as the Treasury general account drains lower. I’m definitely very closely watching money market funds and T-bills on the very front end trading negative. So it’s still a very fragile state to see how things are going to shake out from these policy decisions.
Insider: Renee, on equities, thinking back to the last year, what are some of the most profound changes you’ve seen in terms of how stocks are trading and the market in general?
Renee Yao: I completely agree with Nancy. Liquidity definitely became an issue during the market sell-off. Take March for a special case, what we observed from a micro perspective is we not only saw a market crash, but we also saw a liquidity crash. And the way we verified that was by looking at the spread of the S&P 500 names. So just like the Treasury yield, S&P 500 names are supposed to be the most liquid names of all the traded instruments. So the spread of those stocks are supposed to be the tightest. Stocks like IBM, Apple, their spread is less than say 2-3 basis points, meaning you only need to pay 2-3 bps of the price in order to trade the stock.
However, during last March, what we observed was the spread of those stocks went up from, say, 2-3 bps to, say, 15-20 bps. So that’s a huge jump. And that, combined with the increased volatility and increased volume of trading — we know that in March the volume was very high — that tells us that there was a general deleveraging going on, which means a lot of people were having similar quarterly longs and quarterly shorts, and when things started to go south, they started to sell their longs and buy back their shorts. Because most of the people have those similar quarterly names, they ended up selling the same longs and buying back the same shorts.
So that’s why even if we saw the volume was high, the spread was still wider, meaning the liquidity tended to be on the one side: it was either buy or sell, not buy and sell. So that’s why we saw the liquidity crash as well.
We saw similar things happening in this January during the retail investor events.
Insider: How well-equipped do you think the market and the system is for an event like that again? The Fed obviously swooped in on the fixed income side pretty quickly. So is that is that sort of the best that can happen to remedy that kind of liquidity crisis again, or is there anything on your mind that could be put in place to ensure that markets function a little more smoother next time we have an event like that?
Davis: I think we need more market makers. The general problem is there are not as many market participants as there used to be. And it’s also more concentrated, with certain market participants like Citadel owning a huge amount of the order flow in the stock market. I’m not a stock market expert, but it definitely seems like it’s highly concentrated with a couple.
We need a broader market-making group, and asset managers are not market makers. So that’s the thing to really keep in mind: we’re not liquidity providers, that’s not what we do as fiduciaries for investor assets.
Yao: I completely agree with Nancy. I think the market providers who are supposed to be providing liquidity are important. And right now we see a big concentration in that area.
And also I think central banks are doing a good job in terms of calming down the market. We saw at least three rescue packages since last March. I think that that definitely helps in providing liquidity. Of course, where does that money go is another huge topic where we can spend a long time discussing it. But I think central bank control combined with market-maker participants should be good steps in terms of calming the volcano in the market.
Insider: One big theme that emerged in the last year is inflation, and more specifically what you could call inflation phobia, or the fear that because of all of this stimulus and just how quickly the economy is recovering, you could see inflation return in a way that we haven’t seen before. Nancy, obviously your product is designed for a moment when that kind of thing actually happens, and so I’m curious to hear your take on this debate.
Davis: I think investors need to look at what the market is pricing in, and also how the market is measuring inflation and inflation expectations.
I have a pretty different view of many investors when they’re talking about inflation expectations. They’re talking about the level of breakevens which is implied between Treasuries that are nominal treasuries, just regular Treasuries, and then Treasuries that are TIPS, the inflation-protected security.
But I think the issue that I see with just using that metric is the whole measure of inflation goes back to one index. I’m not an equities person, but I think a good analogy would be like saying I own the Dow Jones, therefore I own equities, right? It’s just an index and it’s not necessarily the only way to measure inflation and inflation expectations.
And the one problem that we see with the CPI is the biggest component. Roughly a third of the entire measure is the cost of shelter. And for this measure, it mostly uses owner-occupied rent, and specifically it’s urban rent. And so, given the decline of rents in a lot of our cities from the pandemic, it might not be the best index to replicate new real life and what people are experiencing
In the inflation market, it’s a little bizarre that most people only think about that one index as a way to measure inflation. Our IVOL ETF is trying to solve a way of giving another measure of inflation and expectations beyond just CPI inflation.
And so, I guess to answer your original question, do I think investors should be concerned? I think investors just need to think about how they measure inflation. And I think it’s something that should concern everybody, whether you’re an institutional investor, an endowment, a pension fund, whoever. Inflation is a real thing that we have not had in a long time, or runaway inflation, really, since the seventies. And I think it’s just out of most investors’ minds. Most rates traders really have never seen a bond sell-off like what’s happened in the last three months. So I think it’s just the time to focus on diversification and also focus on diverse thinking.
Insider: What are some of the more nuanced ways that you would suggest to study inflation expectations?
Davis: What we like to focus on is the different levels of interest rates at different periods of time, sometimes called the term premia. The central banks around the world set policy rates, but the market sets the term premium. So if a policy rate is, say, zero or 25 basis points or in that range, you have different interest rates at different periods of time. That’s largely where market participants will lend money, and we think that is a more market-based measure. There are other things that go into the term premium beyond inflation expectations, but that is a way of looking at where the broader market is saying “this is where we will borrow or lend money in the future.
Also, we like looking at the global market, specifically the OTC swaps market. Most corporates around the world, whether you’re US corporate or you’re AstraZeneca or Sony, anyone in the world who issues bonds in US dollars will hedge their interest rate exposure in the swaps market.
So we think it’s a more global way of measuring the term-premium inflation expectations in the future that’s not just linked to — the US government does the best they can, but — the CPI. The index is calculated just by one entity. It’s the Bureau of Labor Statistics. And so the BLS creates a CPI index, and we just think there are other ways to think about it, and using the OTC markets are a way of getting a broader view of where the global economy is thinking about where US inflation is going.
Insider: Asides from the inflation story, another big one that’s cropped up is the rise of the retail investor, particularly on the equities side. How has the retail investing boom impacted your process at all? If it has, I know that AI is one of the big parts of your input in terms of what stocks to buy and what not to buy. What’s that technology telling you about what’s happening on the retail side and how has that phenomenon impacted your process, if at all?
Yao: From our observation, the retail investor’s involvement, or increasing percentage of the market shares, actually began since maybe March of last year. So it’s not like this January they suddenly became a huge force. We’ve actually seen that happening since the beginning of the lockdown.
For example, one type of data we used before lockdown was realtime GPS location data, in which we track people’s foot traffic. And naturally, during the lockdown,that data became quite sparse. And at the same time, we noticed that what we call network traffic data, meaning people’s online discussions at Twitter, bloggers, forums, Reddit, became very active. So I think it’s probably because of lockdowns and that people became more active online.
Those discussions were less concentrated on stocks that are in mid-cap, large-cap names. Most of the discussions we saw last year were mainly focused on pink sheet stocks or micro market-cap stocks. It was only this January that the discussion seemed to be focused on some of our small- to mid-cap names that really have some kind of overlap with the professional money managers like us.
In short, our AI system was already taking that information into consideration for a long time. So what happened in January was no surprise for us.
The reason specifically for the GameStop or January event was because the SEC requires the long-short managers to report all our positions. For some of the managers where their turnover is less frequent, they probably hold their positions for a long time. So their holdings for last quarter and this quarter will probably not change much, and that’s publicly available information. So if the retail investor has formed an opinion on some of the stocks they’d been shorting, then that will probably make the long-short managers more vulnerable in terms of similar events like January.
In terms of what happened in January, first of all, the concentration of several stocks, like whether they’re mid-cap, small-cap, theoretically wouldn’t impact the market that much.
However, because some of the managers have a huge position in those shorts, in order to meet their margin calls, they have to sell their long positions in order to meet their margin requirement. And that has again caused a general de-leveraging in quarterly longs and a buyback in quarterly shorts. So that’s actually a quite similar scenario we observed to last March when this general de-leveraging was caused by the market crash
So if you have quarterly longs and quarterly shorts, that’s a problem that we’re going to foresee happening again and again because when things are going south, everybody will reduce their risk.
In terms of how much impact this will cause in the long-term, I think I agree with what Nancy says. We should probably add more liquidity providers so the retail investor will have different channels to spend their effort on, so that way we can reduce the risk of concentration. That probably, in the long-term, will address the problem from happening again in the future.
Insider: Nancy, the bond market has been very insulated from all of this, maybe because it’s too sophisticated or because Treasurys are not something a lot of nonprofessional folks can latch onto the same way they understand what a Tesla or an iPhone is. But what’s your take on retail participation in the bond market?
Davis: Generally, the fixed income markets are, I’d say, more complicated than the equities. If you’re looking at interest rates, for instance, there’s no fun narrative about management teams or products or things you can touch or feel. And so generally I think many both institutional and retail investors just don’t have a lot of focus on the rates market. The rates market includes the Treasury market, as well as all the interest-rate markets that are actually even larger than the Treasury market by many measures.
And so we think it’s just an incredibly important market. It’s a very big market, but most investors are more focused on companies, whether it’s corporate stocks or corporate bonds or the stories that they tell. And I think a lot of that has to do with probably the media, that it’s just more interesting to hear about people and what people are shifting to. Whereas talking about interest rates … I find it quite exciting, but I think a lot of investors on both sides of the table, institutional and retail, outsource areas like fixed income investing to fund managers because it is a pretty complicated market.
Insider: As we start to wind down, I wanted to ask about some of the opportunities that you’re seeing now that we are, hopefully, past the worst of this crisis. Some of the winners or losers are more evident across the board. What are some of the opportunities that you are seeing and seizing upon in this post-pandemic world?
Yao: Obviously the past year has been quite different from what we saw historically. We saw a lot of unique events that never happened before. So those posed a challenge for managers who are doing traditional quantitative investing because traditional quantitative investing, all traditional machine learning, relies on historical data. The fundamental methodology is history will repeat itself, and then training models by historic data.
When you see some of the rare events like what we saw last year, it will be challenging because you don’t see much of that historical data exist. We saw quite a divergence in the space last year in terms of performance: even some of the very well-known names have been facing a quite challenging time.
Going forward, we’re probably going to see more and more events like this. So the traditional approach of trying to train the models through historical data alone will probably face more challenges going forward. I foresee that normal people will try to get into the space of AI because that’s really a modern technology, and people already see that that modern technology can be used in many different fields.
Like Google uses it in playing games, Tesla uses it in auto-drive, Apple uses it in Siri. People already see the wide application of AI in many, many different fields. So it’s sooner or later that we’re going to see the wide application of AI in the financial space as well. We would definitely seize the opportunity of this dynamic environment for the AI model and then try to deliver more robust and consistent results for our investors.
Davis: We do think interest rate volatility is a very, very interesting market. We do think there are lots of opportunities there.
I think generally most fixed-income investors are short volatility from passive allocations to mortgages. I think that’s one thing we have to remind people about the financial crisis is in the United States, a homeowner can prepay their loan whenever they want. Therefore, if you own, say the Barclays agg., for instance, it’s about 20% of that index, which many investors, whether they’re active or passive, are benchmarked to. About 28% of the Barclays agg. is mortgages. And therefore those financial owners of mortgages are short options to the homeowner. And therefore mortgages are short volatility.
And so I think it’s very important for investors to acknowledge that and realize that if their fixed income portfolio is meant to potentially diversify the overall portfolio, it might be an important time to think about how you can add things that have long-volatility exposure that are not equities. There are lots of strategies that access the equity options markets in ETFs or mutual funds or various different fund managers, but there’s not a lot of choices from the fixed income point of view, especially for long fixed income. Most fixed-income funds are actually short volatility from their mortgage exposure. So we were very excited about providing an access product to investors by listing the IVOL ETF, which is long fixed-income volatility.
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