QE and the portfolio puzzle: James Saft

May 16, 2013

May 16 (Reuters) – Quantitative easing may well be pushing
investors to hold more cash rather than risk assets, blunting
its impact as monetary policy.

Known as the portfolio rebalancing channel, the thinking
behind QE rests partly on the assumption that buying up
government bonds will drive interest rates down and entice
investors to tilt their holdings towards riskier investments
like stocks. That in turn is supposed to goose investment and
consumption.

Unfortunately, that assumption may be running afoul of, or
fouling up, the way in which most investors construct their
portfolios, according to Toby Nangle, head of multi-asset
investments at London-based Threadneedle Investments.

He argues, convincingly, that by driving rates to
rock-bottom levels, government debt can no longer properly play
its role as ballast in an overall portfolio, steadying the ship
and allowing investors to take on more risk than they otherwise
would dare.

“Despite working in asset management for sixteen years, I
have never met a major, sophisticated, institutional
end-investor who did not believe (with a good degree of
confidence) that on a five-year horizon stocks outperform
bonds,” Nangle writes in a note to clients. (here)

“This begs the questions of why give out bond mandates at
all when clients could go all out on their favorite asset? The
answer, of course, is that they care about the volatility
of their overall portfolio returns.”

In a normal market, government bonds and stocks are
complementary assets; owning the former allows you to hold more
of the latter for a given level of risk tolerance. That’s
because although both assets are quite volatile, when held
together in a portfolio they actually produce less volatility.

Investors care about volatility – deeply. Suffering swings
in value isn’t just stomach-sickening, it can be ruinous, both
for the careers of the asset managers involved and for the real
needs of the owners of the capital.

And indeed, the data shows – and this is elementary
portfolio construction – that mixing longer-dated government
bonds with equities leads to less volatility than would be
suffered if you held either asset in isolation.

Government bonds, therefore, are not just a hedge, but a
hedge with a positive yield. That, in fact, is a principal
reason for their popularity.

THE QE EFFECT

Now consider what happens when government bond-buying lowers
the yields on those bonds to essentially nothing, or to a
negative yield in inflation-adjusted terms. And also consider
that under QE you as an investor are participating in a market
dominated by one buyer – one whose motivation isn’t profit but
jobs and inflation and who might if it served its purposes at
some point in the future become a massive seller.

“Most developed government bond markets now achieve little
for my portfolio and I have sold them down to zero. I prize
those markets that do offer the promise of offsetting equity
volatility with a positive yield and use them to maintain chunky
exposures to the most attractive equity markets,” says Nangle.

So, what then to hold?

The problem is that most of the available assets other than
government bonds which have a positive yield, such as corporate
bonds, are much more highly correlated with equities. That means
that they add risk and volatility to a portfolio.

That leaves cash, which has zero return but which doesn’t
have the capital loss downside of a bond. Sadly, if you hold
more cash you need to cut your exposure to equities or again
take on more risk. Either way, QE may be having the unintended
effect of driving some to hold more cash.

So what are investors really doing?

A look at markets would seem to indicate that most are
stepping up their risk, but the evidence isn’t all one way.
While money market holdings, in the U.S. at least, are down
substantially from credit crisis peaks, they are still at
historically high levels. And cash assets at commercial banks
have skyrocketed, undoubtedly for complex reasons, but something
which can be clearly read as showing household and corporate
caution about the future.

As for QE, this all adds to the impression that its success
as monetary policy is unproven.

For investors the bottom line is that the world has become a
riskier place, and central bankers are forcing you to share the
burden.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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