What the Market Crash Says About How Investing Works

way through the financial system. So you're gonna hear Joe and I talk a lot about how weird it is that we haven't seen any big trading blow ups just yet. Of course, since March we have had a few, notably a big oil fund in Singapore and also a hedge fund called Malachite in New York. I think, if anything, it makes the episode more interesting and the themes discussed

probably more estion. So I hope you enjoyed. Thanks for listening. Hello, and welcome to another episode of the All Thoughts podcast. I'm Tracy Allaway and I'm Joe. WI isn't all so, Joe? You know what I've been thinking about quite a lot recently. Um, Well, I don't know. Is it the same thing that literally everyone across the entire world can't stop thinking about and dreaming about and talking about or is there something else going on? Wait? Are you thinking of the virus or

the market sell off? I think I've been exposed to financial markets for too long because they're sort of both entwined in my mind. I literally like dreamed last night about both the virus and the market crash, and I have not thought about anything else. So, but now, what is the specific thing that you yourself are thinking about these days? Okay, it's kind of an offshoot of the market crash, and it's basically, uh, investor blow ups, So okay,

that's that's timely. Yeah. So one of the interesting things about this particular sell off is we still haven't seen a bunch of investors really get taken to the cleaners just yet. We've had a few, um, one of our Bloomberg colleagues wrote about the hedge fund in particular. But you can imagine with everything that's gone on in the market, you're going to get more and more of these stories emerging. Yeah.

I mean, it's the things that things are moving so fast right now that even by the time this recording comes out, we might hear a lot more investor blow ups. And the one of the reasons, I think we will, and one of the is because we've been seeing, you know, like so many tried and true strategies in the last

couple of weeks have just completely uh failed essentially. So various hedges that investors use to mitigate volatility in their portfolio, whether it's treasuries or whatever, haven't behaved the way, all

kinds of dislocations. So ay, we're almost certainly going to get those blow us and be I think the conditions are now in place from the intensity of the moves that we've seen in recent weeks that will sort of finally cause some of those shoes to drop even beyond just the you know, the sell off so to speak, exactly right. And a lot of those strategies were things that people supposedly had piled into, like selling volatility or risk parity where you're sort of relying on the inverse

correlation between bonds and stocks. All of those seem to fall apart in the recent sell off. So my question is, if you're a professional investor, like a hedge fund or a dealer or something like that, what separates you from the crowd when it comes to your investment strategies? Because, like I said, it feels like a lot of people have sort of just crowded into the same thing in

recent years. Yeah, it has felt like that, and it also is it's been this puzzle and I've certainly like thought about this since well before the crisis hit, which is that on the one hand, you don't want to just pile into the same strategies as everyone else. Everyone everyone knows that, Uh, that's not a particularly desirable it's hard to stand out. On the other hand, for essentially the last decade, we've had this situation in which the winning strategy is to go all in on high beta

and shortening volatility. And if you did anything other than that, essentially for a decade, you faced the situation or like and you have to write a quarterly in estment letter and your to your clients it's explain why you underperformed yet again, So there has been this real pickle where there's been one dominant strategy for so long and uh, if any deviation meant you probably were under performance. Yeah, exactly. There's been a real tension between doing your own thing

and profiting from basically just following the flows. In what has been for the past ten years of really momentum driven market but on this note of sort of standing out from the crowd or um coming up with an

edge in professional investment. It's kind of interesting that when people talk about business in general, h and in economics, people are always talking about competitive advantage and you're supposed to organize yourself around what you do best and organize your business around it, and that's what's supposed to make you successful. But when it comes to professional investing, you

rarely hear that. Yeah, absolutely right. Okay, So today we're going to be speaking with someone who's actually been on the show before, but who has written a book exactly on this topic competitive advantage in investment and what it means to actually be a big professional investor and how different types of investors will approach investing in different ways. Uh So, our guest is Steven Abraham's. He's a former

Deutsche Bank analyst. Um As I mentioned, he has been on the show before where he was talking about the changing world of the sell side analyst, which is a really good thing to listen to. But he's now over at Amherst pure Pont. He's the head of investment strategy over there, and his book is out in April. It's called Competitive Advantage in Investing, building winning professional portfolios. Steven, Welcome to the show. Hi Tracy, Hi, how are you good?

Thank you for joining us. Absolutely exciting times. Um So, maybe just to begin with, what do you think about the big sell off recently? Pretty uh, pretty dramatic. Oh, it has been. It has been a drama of historic proportions. There's no doubt about that. I would say, unfortunately for some the dramas probably not over. I know that, as you were mentioning earlier, we've all been waiting around to see if all of the various players are going to make it through uh, this kind of volatility, and as

you pointed out, we've been doing okay so far. But I would say just within you know, recent days, we've started hearing that there are some portfolios that are in serious trouble and and may not make it so well, we're going to be watching things very closely. Right. It seemed to take a step up in the seriousness really over the last week, and I think there's a good time to remind let listeners know that by the time they hear this, the entire world may have since changed again.

But we are recording this on Monday, March twenty three, so just so that people have a frame of reference,

because again, things are moving so fast. But you know, it's one thing I feel like for the value of risky assets to decline and stocks decline, and we all know that stock market crashes are possible, but I think over the last two weeks, what we've really seen on top of that, especially over the last week, is that various hedging strategies that people might have put in place to mitigate a stock market decline or some other risky

asset decline, they've suddenly like stopped working as liquidity has started to vanish. Yes, yeah, this is really a as you're pointing out, Joe, the normal relationships between assets and hedges, or between in one asset and another in many markets has completely broken down. And underneath a lot of this

is just a historic reach for cash. That's true at the level of individual businesses up and down Main Street, but it's also true with the level of some of the highest quality investment grade companies that apply their wears day to day around the world. Most of those companies are looking at economies that are effectively coming to a complete halt and could remain basically closed for thirty to

sixty nine days. Nobody is quite sure. So they are stockpiling cash and in the process basically selling everything that they possibly can, and that includes securities. So the usual ideas of stocks being richer cheap or bonds being rich or cheap has been uh completely subsumed under the issue of what is liquid and what can be sold and

whatever is liquid is definitely getting solved. So just on that note, can we talk a little bit about what traditional investment theory would have told us about that big scramble for cash, Because on the one hand, there is a saying that in a crisis, correlation goes to one and everything sort of sells off at the same time. But on the other hand, you know, the reason you pay more for investment grade or something like the U. S. Treasury is because it's supposed to be safe in times

like this. So what does investment theory actually tell us about what's going on here? You know, investment theory, probably the most relevant theory here is kind of traditional monetary policy theory, which says that when people have doubts about the credit worthiness of their counterparties, than any typically does not flow, and the big issue is that with economy is coming to a sudden stop, it really is difficult to predict which companies have the wherewithal to make it

through this crisis. Central banks have really been flooding the market with very plentiful and very cheap money, But the issue is the credit worthiness of the people who need it most now. Traditionally, this is an issue that monetary policy assumes is going to affect banks. You know, the depositors look at the banks, they worry that the banks are making loans that are not prudent, and they try to withdraw their deposits. Here in some ways it's just

the opposite. The banks have tremendous amounts of money, but they're worried about the credit worthiness of the restaurants and bars and taxi businesses that right now, for practical purpose as are shut down. So UM many companies are simply looking at whatever can trade, whatever might be liquid. So it's really monetary policy and UM the ideas around liquidity that apply here, and those have dominated any idea of

the ability to UM call relative value. I want to get more into some of the ways monetary policy can help this crisis, including again some of the things that we're just announced this morning, but before we do, I just want to sort of go back to this idea of historic grab for any cash that people have, the likes of which maybe we've never seen before or very

rarely seen. One of the things that's really striking is in the last couple of weeks, how treasuries, which are almost cash, like the sentence that they're completely backed by the full faith and credit of the government, counterparty risk free, even those started get selling off, started to be sold off a little bit because if we think right like this, like hierarchy of money, Yeah, holding a treasury is really great for you know, lean times and you want to

be saved, but if you need to make a bill payment tomorrow, you still just want cash instead. Correct. Yes, So in the treasury market, um there has been surprising amounts of illiquidity. Usually in the treasury market, liquidity comes in a couple of tiers, and the most liquid tier is the most newly issued notes or bonds, and those still seem to be maintaining liquidity. But then the older notes and bonds have lost um surprising amounts of liquidity,

and there have been very large leveraged treasury portfolios. Traditionally, those portfolios would have reached through the broker deal or bank network for financing. They may have used repo or other forms. Many of the balance sheets that normally would lend to them have been limited in their ability to expand credit. So, among other things, this starts to get at some of the core competitive advantages or disadvantages of some of these investment platforms. The leveled players really don't

have any source of funding on their own. Banks now have sources of funding. Traditionally they have sources of funding through their deposit base. Now the FED and other central banks around the world are flooding the bank system with money. But some of the post crisis rules on UH the proper ratios of debt to equity, and other issues limit the ability of banks to lend endlessly, and that has partly constrained the system, and it's led the FED, I think,

at times, to struggle with what it's supposed to do next. Yeah, So you had a bunch of these levered funds that were effectively picking up pennies in front of a steam roller for years by exploiting the difference between the more liquid futures and the cash US treasuries, and then that trade blew up rather spectacularly a week or two ago, and then that ended up infecting the U S treasury

market and causing all sorts of problems. Uh. Just pass forwarding to today again, Monday March, just before we started recording this, the Federal Reserve announced its latest attempt to soothe the market, and that includes potentially unlimited QUEI and also some help for companies and munies. Steve, I know you've been thinking a lot about this, but is this the right thing for the FED to do? Are they on the right track or would you be encouraging to

do something else at this point? Well, probably the most important thing the FED did this morning was announced a couple of new facilities that allows the FED to buy a much wider range of assets directly from investment portfolios and businesses, so this is now no longer limited to

the typical um set of primary dealers. They announced the term Asset Lending Facility, which basically will buy all kinds of asset back securities as long as they have the proper ratings, and they will buy those securities from any eligible um US portfolio. They also announced a series two programs directed at the corporate market, one that will buy corporate debt directly from US companies with headquarters in the United States and doing major business in the United States.

So this effectively creates a direct connection between investment grade companies and the government balance sheet. They announced similar programs for secondary corporate debt, and they expanded the program that they announced a week ago for commercial paper. So the FED is slowly stepping in the direction of trying to

address this cascading illiquidity across these markets. And my guess is these new programs for ingressment investment grade paper will have um a tremendously good effect and should start to eliminate some of the volatility. So just to help people understand, it's not that, you know, we're still going to have these sort of main street economic crisis for as long as people are locked down, as long as the virus is here and so forth, and that's going to continue

to ravage the economy. But in the meantime, high quality companies can at least ease up theoretically a little bit on grabbing hold of any cash that they can in the system, because for not for the moment, the FED will backstop essentially their short term borrowing. So that should the idea is that eases some of the overall desperation that every person in every company everywhere has for liquidity. Yeah,

exactly right. Investment grade companies, large investment grade companies at this point essentially have substantial direct assess to the FED, and my guests would be the Fed's going to continue providing and expanding that access as long as it sees signs of stress. The b S facility starts to walk down the path of providing better access to main street, and that would have to come through the willingness of

banks to make credit card loans and auto loans. The asset back facility basically has elements that will allow auto dealers to finance cars and other vehicles more easily. But you still, at this point, I think, have a problem getting credit to a lot of smaller mainstream businesses. Maybe the FED has a couple of tricks left in the bag, but my guess is you're really going to need some

kind of physical policy. So I wanted to go back to something you touched on earlier, which was this notion of the dealers or the banks being a little bit more restricted in terms of the amount of risk that they can take, and maybe some of that risk having shifted to the buy side, because a lot of people right now are talking about how the current crisis resembles not necessarily Lehman Brothers in two thousand and eight, but

more lt CM or long term capital management. Back in they dabbled in a lot of derivatives UH and basically exploded UM. So I'm just wondering if if that's the right framework to look at the current state of the financial industry, and if that's the reason why the FED is quite focused on expanding UM the parties that it can actually do business with. When it comes to QUEWI, the biggest difference between this crisis in two thousand and eight is that the crisis in two thousand and eight

was in the financial system. The crisis in is outside of the financial system. UM really at its core in corporate America UH, and as a result of corporate America being stressed, it's a problem then on main street and in households pretty much around the world. The FED as a central bank is really really well equipped to pour

water on fires inside the financial system. Outside the financial system, it has to get a little bit more creative, because the core issue here is the fundamental credit worthiness of main street borrowers and many homeowners. The best possible solution, what which was in some material within the last few days that I published in Financial Times, is to provide government guarantees of emergency bank loans to otherwise credit worthy businesses.

We have a problem that the economies of ground to a sudden stop, but I think it's widely expected that after a ninety or a hundred and eighty day period, many of these businesses will be viable again. So the trick is bridging that period by providing credit. Banks I think have plenty of money, but I think any banker hesitates to lend to a business about to see its earnings evaporate. If you had, if you had the government provide guarantees, I think banks would have a lot more

courage in that situation, right, I really Uh. There was this great LARRYUS Summers quote that he said a couple of weeks ago, and I keep thinking about it. He's basically saying, like somehow I forget his working exactly, But essentially the challenges how do you freeze financial or so how do you freeze economic time, while uh, financial time continues in its current state, and this idea is like, Okay,

everyone knows we have to stay inside. Everyone knows that there are a lot of viable businesses that will need to shut their doors for days or whatever. But the bills keep coming in regardless and essentially and as you say, that sort of outside of the monetary system and subside of the banking system per se. So it's somehow going to have to be an Act of Congress to come up with a solution that lets everyone pay their bills during the essential time of the FACTI lockdown. Yes, that's

exactly right. So, Steven, I wanted to get to your book, uh, and we spoke a little bit about it earlier. But you know, when people talk about investment strategy, they're usually treating all the investors in a sort of similar way. But as you point out, people tend to do things differently according to their competitive advantages. Could you maybe just walk us through, uh, the premise of your book and

why this was something that interested you. Yeah. Absolutely. I think that when you sit in a seat like mine, where you're really advising a wide range of investors, you start to see over time that the players matter just as much as the market does when it comes to UM investing. You can UM look from banks to insurance companies,

mutual funds to hedge funds, reets, sovereign wealth funds. They all operate UM with very very distinct advantages and disadvantages, and those kinds of things not only shape what they buy how they use the as assets, but UM it also ends up turning around and affecting the value of those assets in the marketplace. And they're just plenty of examples of that, including the kind of markets that we're

looking at right now. And UH I thought for years that we needed something that went through these different kinds of investors and talked about what their strengths and weaknesses might be and how it affected assets. And that's what led me to write the book to expand this further strengths and weaknesses of different types of assets. What does that mean specifically, Well, I'll give you an example. It's very relevant to where we are now. UM. Let's take

UM source of funds. Some investment platforms just have tremendous, tremendous advantage in the variety and the low cost of their funding. And for example, right now, the the eight hundred pound guerrilla on that front is the banking system. So banks traditionally have a really wide range of sources of funds through their retail deposit base. Some of their retail deposits are a kind of fast deposits from big

corporations that are moving money through their accounts quickly. Other other deposits are very very long, steady and stable UH

sources of funds. Like, for example, if you look at my checking account, I've probably had some at least minimal balance in my checking account for decades, So banks could use my money that's there for decades, your money that's there for decades, other people's money that may be there for far shorter periods of time, corporate money which may come in and out day to day, and they can use that to buy or fund a wide range of

not only loans, but securities. If you want to go to the opposite extreme, you could look at hedge funds, for example, or reads, which usually borrow based on repurchase or repo agreements UH, and those repo or repurchase agreements often last only for a day and have to be

renewed every day. Right. That leads those kinds of organizations kinds of investors highly subject to markets where suddenly there's a run on liquidity, and those are the those are the folks that are struggling at this point, right, some of them would have done that levered US treasury trade that we just described. So I guess the question is knowing that you have that sort of short term day to day funding, shouldn't that change the way you invest

potentially or at least the way that you hedge. Absolutely? Um. I mean when it comes to the way you invest, and you see this in the portfolios at least most of the portfolios of prudent leverage investors, that almost forces you to hold highly liquid assets. So does it make sense to have levered portfolios of treasuries? Um, Yes, it probably does. Would it makes sense to have leveraged portfolios

of agency mortgage backed securities? It probably does. Would it make sense for you to have leveraged portfolios of less liquid assets like um certain forms of a corporate debt or loans that may not be easy to sell on

short notice. Once you start leveraging less liquid assets, you begin to take much more risk uh of a liquidity crunch of the sort that we're in now, and what you can see is that in today's marketing current circumstances, lever portfolios of the most liquid assets have been able to delever, not necessarily um in a pretty fashion, but nevertheless they've been able to de lever, while levery portfolios of less liquid assets have struggled, and at times I

think some of those organizations have been on the brink of failing to meet calls for additional margin, additional cash and could go out of business. So a lot of this I think makes sense to people right now. I mean, we're looking in a market that's been you know, arguably some of the most most volatile, complete turmoil that many

people have ever seen in their careers. But you know, like in the normal times, you know, two thousand thirt was there, Just like, how do you get this message across and how do you deal with the issue that I was sort of talking about at the beginning, where prior to right now, the dominant strategy for an investor would essentially just be too go all in on high baya or short volatility or just that that historical correlations UH will maintain, Like how do you how do you

apply these lessons to non crisis periods and be a competitive investor. Well, for example, if we we step outside the current situation, taking insurers for example, UM, I know it probably is not the usual way people think about insurance companies, but when you hand when you pay your UH life insurance bill or your auto bill, in many cases, you're really handing those insurance companies a dollar that at some point in the future they're going to hand right

back to you. I mean, an auto UH policy is probably the simplest. You don't expect to be in an accident, but if you are fender bender or otherwise, the auto companies are going to pay to get your car fixed. You you could have held that dollar in your savings account, but instead you're giving it to the insurance company, and

the insurance company gives it back to you. Between the time you give it to the insurance company and the time that company pays it back to you, it has the opportunity to invest in a wide range of assets. So with life insurance companies, especially since the time between getting the dollar and paying it back is so long,

life insurers are just beautifully equipped for owning illiquid assets. UM. They can hold loans of wide range, they can hold securities that are private play easements instead of public securities. They're able to invest in real estate, where the return to the investment really requires a long horizon and the ability to tolerate potential swings in prices. If you were running a mutual fund, in contrast, it would be very

difficult to hold securities that have limited liquidity. That's because a mutual fund has to provide daily returns to their shareholders. So just if you look at funding, and then you look at other aspects of these platforms, like how the accountants measure these things, some are really well equipped to hold the liquid assets and others aren't well equipped. You can see that in a bunch of other dimensions as well. Where do you see the most extreme liquidity mismatches in

the current sell off? Is there something specifically that you're um that you're watching out for. Well, in this setting, the place you always have to look first are the most highly levered investment portfolios as well as the most highly levered corporate balance sheets, and both of those markets are struggling, both of them. Um. So, we've heard reports over the last couple of days of large hedge fund

portfolios that are circulating and looking for bids. We've heard of um significant demands for liquidity from real estate investment trusts, which also tend to be leveraged. And you can clearly look at the corporate world, to some extent investment grade, but very very clearly in the leverage loan market, where corporations are drawing down their credit lines and trying to fortify their balance sheet for periods of you know, really

difficult earnings ahead. Those are the places I think that are right now most at risk, and we're seeing that they'll they'll pay for liquidity at almost any price. How do you identify opportunities though, because you know it's really bad right now, it also looked really bad a week ago, And if you try to be here, I said, okay, I'm gonna be the liquidity provider. You know, I'm gonna

be the liquidity provider that jumps into the panic. And you said that a week ago you might already be you might already be finished, you might already be taken out. So how do you think about risk management and exploiting these opportunities where people will pay almost any price for liquidity,

but not blowing up yourself in the process By mistiming. Well, So if I started with these investment platforms, the strongest players in the market are going to be the ones with the most capital um, the deepest and lowest cost, and widest variety of funding. Those are the places that

are going to have the strong hand. You might think that that would include banks, and to some extent that might be true, but regulations limit the degree of credit risk that banks can take, so while they have great advantages in capital and funding, have some disadvantages in regulatory constraint. Insurers are also likely to be in a strong position, especially insurers that have strong capital and deep access to funds.

So that would probably include most of the larger players and some of the players that are using the investment grade bond market to raise cash at this point. I mean, notably, you've seen Berkshire Hathaway in past crises right to the rescue, and although that clearly reflects the genius of war and Buffett, there is no doubt at all, it also reflects the strength of the insurance balance sheet that he's playing off of.

So those are the those are the strong platforms. Those platforms have the ability two buy assets that otherwise would be in free fall, they're not subject to usually to margin calls. Um, they're accounting rules are very very kind two assets that show price volatility. So what we've been advising investors to do when they have balance sheets like that is to buy fundamentally sound cash flows at widespreads and those would in flute some government back cash flows

that are trading at distress levels. And when it comes to the corporate market, cash flows from corporations that have adequate liquidity to weather the next three to six months and have the potential to come out of this crisis potentially stronger than when they went in. And those would be the kind of investments that right that we've been advising. So then you don't have to be a hero. It's not really about timing the bottom or anything like that.

Or this fell another ten percent after I bought it, but take there are looking for opportunities in which the spreads are so wide and the sort of uh predictability of future cash flows for whatever reason, as you mentioned, something like our insurance et cetera, are so consistent that your your margin for error is quite large. Yes, I mean, timing might be everything in comedy, but most research shows

that it doesn't really amount to much in investing. So if you look at some of these stronger balance sheets, they are going to be able to absorb these assets and honestly um provide good returns to their shareholders for years and years to come. Right, Stephen, we really appreciate you coming back on the show, and we're definitely gonna look out for your book when it comes out and equal thanks so much, great, Thanks Tracy, Thanks Joe. Thanks that was great. Joe. I was just thinking, uh, Warren

Buffett has actually been notably absent from the recent sell off. Yeah, right, like we have yet to see uh an op ed from him in the New York Times saying, the buy American I am, and I think, and I wonder if like everyone is just so shell shocked, what does that just maybe that includes Warren Buffett? Like the degree of uncertainty.

I mean I don't know, like I mean, I don't know like what what he's thinking, but like the degree of uncertainty here at the sort of path dependency and the speed with which things can fire, a lot of control. I mean, like look in two thousand and two thousand nine, we always knew there was a we didn't know that they were going to get there, but it was you know, as our guests was talking about, it was a monetary phenomenon,

was a crisis of the banks. And you can theoretically always paper over a monetary phenomena, but when you have a real economic crisis where you like really do not know how long it will be before people are comfortable spending money in retail establishments, again, I just then the degree of uncertainty and the desire to hoard liquidity or hard cash when you have it. I just think that's like what makes this almost feels like incomparable to anything

we've seen. Yeah, the speed has certainly been unprecedented. And even in two thousand and eight in the financial crisis, when we were worried about the banking system collapsing, people still went out and you know, bought sandwiches or you know, like their haircut and things like that. That's just not happening in the current situation. So it does raise all sorts of questions. The other thing I like about Steven's framework in particular, this idea of you know, different investors

have different ways of funding themselves, different advantages. It's that kind of detail that I find a lot of investment theory just sort of glosses over, like obviously big investors want to buy low and sell high. But actually, as Stephen was saying, there's a funding consideration there too, and you always want to be sort of matching your funding

with your investment horizon or the assets maturity. Yeah, it's a really it's a really good thing to uh to think about right now in terms of like how people are thinking about whether there are in fact opportunities in this market, right and whether there are vulnerabilities because as we've seen, this is sort of so far. I hope this doesn't change by the time this episode comes out, but so far this has sort of been vindication for

the regulators. Right. They encourage banks to hold a lot of risk to turn out their funding and it's sort of paid off in this situation. But the downside, of course, is that you have a lot of stuff that's just held outside the banking system and might be harder for the Federal Reserve and other regulators to actually help. Yeah,

exactly right. So so far, there's a there's a argument to be made that the bank that the post crisis regulations have done a good job, because we have yet to hear about major concerns with systemically important financial institutions because all of the true risk has been pressed out so so far, there's definitely a case to be made that the regulations are working, as the number of times

you're saying so far in that sentence's nervous. But yeah, yeah, let's hope it stays true by the time this episode comes out. Shall we leave it there? Yes? Okay, This has been another edition of the ad Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe Wisenthal. You can follow me on Twitter at the Stalwart. And you should follow our producer on Twitter,

Laura Carlson. She's at Laura and Carlson. Follow the Bloomberg head of podcasts, Francesca Levi at Francesca Today, and all of the Bloomberg podcasts. You can find them under the handle at podcasts. Thanks for listening. Year to e