Thrown for a LOOP

Fixed weight allocation portfolios are preventing market integration and raising risks of a violent repricing

Summary:

• The Law of One Price, Discounted Cash Flow analysis, and Covered Interest Rate Parity ensuring pricing consistency in financial markets. These show evidence of breaking down

• The death of the 60/40 equity/bond portfolio is as misplaced as its birth

• The increasing trend towards passive investment and systematic portfolio rebalancing is contributing to market inefficiency, with fixed weight rebalancing strategies lacking a self-correcting mechanism

• Despite the uncertain timing of a correction in mispricing, it will occur. Investors are unlikely to time it, and the catalyst is likely to be qualitative rather than quantitative. The current bond/equity mispricing closely resembles the persistent “cheapness” of value, and it’s a reasonable fear that it can persist longer than anticipated

What I’m Reading

Actually listening... I finally had a chance to go back to Michael Pettis’ January podcast with Matthew Klein. If you find the time to listen to this series of seven (so far) podasts, it’s masterful.

Top Comment

Brian observes: Mike, new corporate refinances coming out with very low coupons and priced at big discounts, keeps interest expense down and allows for extend and pretend and even more debt. Perhaps the day of reckoning will be later than we think.

MWG: Brian, I agree this is one of many stopgaps that will be tried. Creates a transfer of value from equity to bondholders that isn’t immediately disclosed. Same idea as NAV loans.

The Main Event

The Law of One Price (LOOP) stipulates that in an efficient market, a security, commodity, or any other asset should have a single price, given that any differences in price should be eliminated by arbitrage. In essence, identical assets should sell for the same price in different locations or different markets, allowing for conversion rates and transaction costs.

Discounted Cash Flow (DCF) analysis is a method used in finance to value a project, company, or asset based on the concept of the time value of money. It estimates the value of an investment based on its expected future cash flows, adjusted for the time value of money. In DCF, each of those cash flows is discounted to reflect their present value, given that money today is worth more than the same amount of money in the future due to its potential earning capacity. In essence, a DCF eliminates arbitrage across time.

Covered Interest Rate Parity (CIRP) is a fundamental principle related to the foreign exchange market, establishing a relationship between the interest rates of two countries and the movement of foreign exchange rates over time. In essence, interest rate parity and forward FX pricing aim to prevent arbitrage opportunities arising from the differing interest rates of two countries.

These concepts are inextricably linked. While the Law of One Price focuses on spatial pricing consistency (across locations), interest rate parity and Discounted Cash Flow (DCF) models help ensure temporal pricing consistency (across time). They help adjust the pricing of assets or cash flows to account for the time value of money, certainty of cash flows, interest rates, and exchange rates. In other words, a dollar returned from an investment in the S&P500 in the year 2030 should have the same risk/time/currency-weighted price as a dollar returned from an investment in Japanese government bonds.

Unfortunately, the integration of markets is showing evidence of breaking down as the increasing rigidity of regulatory regimes and reliance on systematic portfolio construction approaches raise the barriers to the arbitrage needed to maintain these relationships.

60/40? Who?

We are all familiar with the 60/40 portfolio concept, but where does it come from? A quick poll of all readers. Answers revealed below the paywall! (Remember you can request a free subscription by emailing subscriptions@yesigiveafig.com if you’re desperate to know the answer)

While 60/40 is perceived as a universal weighting schema, what’s remarkable to me is how few investors actually hold anything that looks like 60/40. For example, in Vanguard target date funds you don’t hit 60/40 until the 2025 retirement fund:

Once you hit the “Retirement” funds, you move to 30/70 (30% equities, 70% bonds):

But these funds are small, representing roughly $100B in total assets. Across the total Vanguard Target Date Fund universe, allocations are roughly 75.5% equities and 24.5% bonds.