An honest account.. thank goodness no Black Swans..!!

Thank goodness the mainstream UK punter has yet to cotton (like the Mandlebrot ref there) onto Taleb lest they be screaming 'Black Swans' .. 'Black Swans' 24/7...

Does the power of herding have the power to move markets? An honest account of a simple fund analyst, left with unanswered questions in the wake of 2008.

Herding: Does money drives markets; drive money?

Back in 2007 I was a fund analyst for a large global investment house charged to try and make sense of fund markets when the credit market ‘crunched’. By the start of 2009 I was on garden leave; reeling from the simple fact that my company had lost 40% of its assets and 70% of its new sales in a very short space of time.

At the time I was trained to believe that markets and economics should run efficiently; the emphasis being on SHOULD. Many believed that investor patterns were wholly entropic (both random and unpredictable) and perhaps that is still partly true but what if they are also sociological, groups of investors following  similar influences from one asset class to another?

Beyond physical events; investment risk is popularly regarded as man-made. If true then it is likely to stem from: Psychology (irrationality and market abuse), Sociology (politics and media) and Technology (access and speed).

Market Cycles: The Absurdity of the Traditional Model.

Behavioural finance scholars have long highlighted a simple fact:  that the fear of being wrong; and losing capital, is stronger than the ambition of beating the market. Meanwhile textbooks drive home the sanctity of an investor’s ‘utility’ (their appetite for risk). However investor actions in the market attest to group-think, where investors overestimate or underestimate their own attitude to risk. When that happens then they stop acting as individuals and they begin to herd.

Markets (and investors) remain obsessed about whether they are in a rising or falling market. These markets became widely known as 'bull' and 'bear' cycles and as high a motivator of investor behaviour as you will find anywhere. Traditionally if this concept holds then we should expect distinct bull and bear markets, they are familiar terms, straightforward and cast the 'bear' as the villain profit-taker and the bull as the hero profit maker. However what if I told you that there is never a clear bull or bear consensus; rather one huge tug-o-war between pundits, prophets and politicians? Investors are subjected to influence to herd towards one argument or the other; it is self-fulfilling that herding then creates the outcome.

Group Think: Are Investors Victims of their own Irrationality?

Market commentators often depict investors as hapless market passengers and many investors will concur. However individualism and herding is shortening the market cycle as investors put greater focus on short-term information over their long-term asset allocation. By doing so they compromise the very allocation designed to meet their needs. Group think is not solely confined to investments of course; it is the queue of traffic in the outside lane of a motorway when the inside lane flows freely; it was the bank run on Northern Rock. Here my interest in group think lies in fund flow herding.

2008-2010: Bond or Bust?

By building samples of fund sales flows I began to chart how investors reacted to different situations, the effect on their attitude to risk and how those patterns changed. Unsurprisingly I will mention the unprecedented drop in confidence through 2008; and the somewhat premature rebound through 2009. Interestingly that recovery in buying patterns by January 2009 pre-dated the market recovery by about 3 months. Buying confidence again fell in October 2009 as the risk of a ‘double-dip’ appeared about 'evens ' with the likelihood of sentiment picking back up.

A key factor during the credit crunch was investors re-pricing the risk in bond markets and its exposure across other asset classes. We called it ‘contagion’ and it displayed viral-like qualities. However sentiment towards bonds had been declining as far back as 2005.

2010-2011: Absolute Uncertainty!

Through 2009-2011 inflows into new absolute return and strategic bond funds grew dramatically. At the same time; despite poor economic outlooks, traditional ‘flight’ sectors such as UK Gilts remained relatively flat. It is now clearer to me that [rightly or wrongly] absolute return and strategic bond funds had become the new ‘uncertainty’ safe havens.

As far back as May 2011 Morningstar flagged a ‘silent crash’ among US fund investors; soon after other agencies were flagging similar dissent across European markets. Outflows and mass retreat into defensive assets appear to have predated the market crash in August-September. The reason may be simple, if every fund manager had to redeem £1 for every £3 invested then their position quickly becomes stretched. At some point the manager may feel compelled to rebalance risk or to liquidate to cover redemptions. Neither outcome promotes a rising index.

If you cross-reference sentiment indicators such as John Gilbert (JGFR) then it’s clear that investors never actually regained confidence; merely they found new ways to invest their growing anxiety.

Conclusions for the Future.

Despite the persistent inflows; into mixed asset funds through 2009-2011, I cannot see an end to growing individualism among fund buying. If we look at the month-on-month changes in fund flow patterns and risk aversion (‘deltas’) then we can that the magnitude of herding has grown steadily and the swing from positive to negative sentiment has quickened.

Why? My reasoning is simple in that fund investing; and the technology surrounding it, is becoming more accessible and faster. Absolute return and life-styling products slowed this trend in 2010 but the risk of disillusioned investors hangs over these sectors. At the time of writing, rising UK inflation may form a key risk for such strategies.

Long-term; as the traditional fabric of company pensions and advisory process fragments, then even greater levels of media influence and herding lie ahead. The current market is ill-equipped for such irrationality, from literally millions of investors, which puts further pressure on already creaky asset allocation models anchored on historical market returns.