Stockholm (Ekonamik) – “Beyond profit maximisation, cost, capital preservation, income, growth, liquidity, funding needs and risk management concerns also inform investors’ decisions. Asset prices are anchored in fundamentals but swing widely around that anchor as investors pursue these other objectives,” explains Max Darnell, Partner and CIO at First Quadrant, a quantitative boutique investment manager from California. He believes that investors need to wake up to the limitations of the three prevailing financial modelling paradigms and embrace an alternative holistic and ecological perspective.
Classical Financial Theory is grounded on too many oversimplifying assumptions, he explains. Darnell also quotes a 1970 article in the Journal of Finance by Eugene Fama, the father of modern finance, to illustrate the pitfalls of the efficient markets hypothesis (EMH). “The … statement that in an efficient market prices ‘fully reflect’ available information is so general that it has no empirically testable implications. To make the model testable, the process of price formation must be specified in more detail.” Finally, “behavioural finance provides valuable insights about human behaviour. It makes a compelling case for why human fallibility explains at least a part of why markets don’t behave as the above models expected. But these insights are more qualitative than quantitative and so resist incorporation into a model framework.”
Instead, First Quadrant follows a fourth path. The asset manager is guided by the understanding that investors are heterogeneous with fundamentally different preferences, reacting differently to different market events. Understanding the catalysts for the actions of different investor groups and how these actions will impact the market is the core of First Quadrant’s approach. “Our edge is in our ability to identify the key market participants, what (largely) rational objectives drive their trading, use this information to anticipate asset movements and position our portfolios accordingly”, says Darnell.
First Quadrant points to practical trading examples that can be pursued through this lens. “In commodity markets, a fall in inventories is normally a catalyst for increased hedging demand as investors rush to pre-emptively stock up, so we can react early to this and position ourselves appropriately,” the CIO explains. “For a bond trader seeking to maximise the yield of her fixed income portfolio, changes in interest rate differentials across currencies create an incentive to enter the forex market, beyond what might be implied by carry trade dynamics”.
This investment approach is not without its academic foundations. The fundamental premise of heterogeneous agents and their interaction with their financial environment echoes the recent Adaptive Markets hypothesis of Andrew W. Lo. Recent work by Vayanos and Villa, Greenwood and Vayanos, Guibaud, Nosbusch & Vayanos has revealed theoretical models and empirical evidence of heterogeneous maturity preferences in the US Treasuries market. Krishnamurthy & Vissing-Jorgensen estimate the credit spread demand curves for individual groups of Treasury holders by financial industry.
However, the insights are not just limited to heterogeneity across investors, but rather also extend to their interaction under varying market conditions. “We find some evidence that when the economy is doing well and risk appetite is high, a shock will have a small effect compared to an environment when the economy is doing badly, and risk appetite is low,” explains the CIO. “Similarly, while historical data on ESG is limited, we find evidence that investors are much more sensitive to ESG considerations at times of crisis or during scandals than otherwise.”
“One concrete concern we have, based on our approach, is that the increase in capital call in proportion to the size of private equity (PE), private debt and alternative investments of institutional investors has increased, ” Darnell points out. “We noticed that in 2008, when these holdings were much smaller, as equity prices tanked PEs specialised in buyouts would call in capital to purchase companies on the cheap. Foundations and other PE investors would sell their equity positions to satisfy these capital calls, thus lowering the equities even further, which created the potential for a downward spiral in markets,” he concludes.
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