The (ephemeral) value of passive management

• In 2020, as in the last decade, those who invested by reproducing the performance of the indices were rewarded even if they were exposed to high volatility

• The markets were once again fueled by liquidity generated in various forms by central banks which obscured the fundamentals of issuers and the economy

• For many this trend will continue because central banks have no alternative, but is it advisable to invest relying exclusively on this factor while the valuations of the financial markets are now double the historical average (S & P500) and the typical signs of an end of the cycle are multiplying out there?

Better to passively go with the flow. The performance of investment made by professional managers over the last decade would seem to teach this. The so-called 60/40 portfolios, that is, those that invest 60% of the resources in shares and 40% in bonds, mainly concerned with reproducing the market indices, have done better, in some cases much better, than the so-called active managers.

The logic of common sense dictates not to discuss the facts. It is worthwhile, however, to make some comments on the results for 2020 and the expectations for the futures. Especially and inflationary one.

What has determined, it must be asked, the brilliant results of passive managers? In other words, what was the fuel that fueled the growth of financial markets and the value of portfolios? In 2020, but also in recent years (in particular from 2012), the answer, in large part, is the role of helicopter money exercised by central banks, starting with the American Federal Reserve. Since the great financial crisis, central banks have gone far beyond their historic role as lender of last resort in money creation, evolving into a force that has inflated the price of assets in the (succesfull) tentative of fixing balance sheets of certain institutions. On several occasions, with different motivations and forms, central banks have supported the expansionist economic policies of governments, extending their effects onto the financial markets. The fundamentals of issuers and economic systems have thus gradually faded into the background: the fuel of central banks has counted (and counts) more and more. In practical terms: why go to work (find quality assets to invest in) if there is a generous father (the central banks) who, by providing money, satisfies everyone's needs? There is no reason, in fact. So it went so far, but tomorrow?

For many, the problem of tomorrow does not arise: central banks, they argue, will not be able to withhold their support for the economic system and financial markets. According to this view, the growth in prices will therefore continue despite the quality of the economic fundamentals. Extremist proponents of this reassuring view say that even the debt level of states is now irrelevant given that rates are at or below zero.

There is no lack of objections in this regard. The most important: you cannot invest simply by relying on the behavior of an institution (the central banks that will not pull the plug that keeps the system alive). Investing by relying on the behavior of a regulator rather than on the value of what one invests in is equivalent to a moral hazard, which is not one of the qualities of an investment. Not to mention that it has led to systemic crises like those of 2007.

Fundamentals do matter. There have been, in past years and in recent times, cases in which the fuel of the central banks has decreased (by "mistake", as at the end of 2019) or there have been market situations in which the power of banks power plants became necessary but increasingly with decreasing effectiveness (for example, the market reversals of last March caused by the start of the pandemic). (Even if, immediately afterwards, the banks multiplied the interventions by “n” times already with evident decreasing marginal utility). In these cases, faithful adherence to the 60/40 theory would have required continuing to invest regardless of the actual schock in the markets. Certainly a very courageous decision which, in 2020, contributed to the brilliant management results mentioned above but exposed the portfolios to such high volatility as to make it doubt that the average investor had a steady pulse and did not exit the room.

In fact, there is also this to consider in the assessments on 2020 and will be more and more the topic of the future: how much risk one shouold take to achieve the performances that the past decade has accustomed us to? How many investors, even if benefited from the final management result, would have consciously accepted to expose themselves to such high risks? We have already addressed the topic of managing expectations in one of the previous letters.

Today, when assessed on the basis of economic fundamentals, financial market valuations are on average double the historical average (S&P500) and reflect a positive sentiment on the economic outlook. The markets, as always, look ahead and discount the imminent overcoming of the pandemic crisis.

We are now, this seems evident, at a new peak in the market where growth justifications are starting to run out. We also testify to some collateral phenomena, for example the growth of fraud on the stock exchange and certain excessive behavior. When liquidity abounds and prices grow indiscriminately, issuers multiply and, with good issuers, those of dubious quality arrive, attracted by the possibility of unloading goods of low value or even damaged on the market. The increase in attempts at market fraud signals, historically, the near end of a cycle, a bit like when the general public starts talking about investments on the stock market: it is a sign that the time has come to go out. There are certainly good reasons to continue following the trend, but we must be aware that the music could stop at any moment, starting, as in the game of chairs, the frantic search for a place to save oneself.

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