The Insidious, Creeping Horror Of Artificially Low Interest Rates

giphy_zombies
Source: Night of the Living Dead

“Volatility is about fear… but extreme tail risk is about horror […] It is not the first act of the horror movie when people start turning into zombies… it is the end of the second act when the hero realizes he is the only person left not a zombie.”

Chris Cole, Artemis Capital, “Volatility and the Allegory of the Prisoner’s Dilemma”

Here is how a mutual fund manager responsible for billions of dollars in client assets is setting his return hurdles:

Bill_Nygren_Return_Hurdle
Source: Google Talks Transcript via MicroCap Club

You should read the whole talk. It is fascinating and informative. Bill Nygren is a well-regarded mutual fund manager. This post isn’t meant to impinge on his intelligence or skill (your humble blogger is acutely aware he is a nobody). What this post is meant to show is how some of the most capable investors in the world have been impacted by very low interest rates.

We know from prior analysis that the riskfree rate of interest has varied dramatically over the last 50 years, and that current rates plot on the low end of the historical range. Here is a visual from my discount rate post:

118_Implied_Cost_Equity_SP
Data Sources: Aswath Damodaran & Michael Mauboussin

So is a 100 bps upward adjustment to the market yield really giving you a conservative hurdle rate?

Nygren is hardly an idiot. But he is running a multi-billion dollar mutual fund. If his team jacks their hurdle rate up to 10% it will get very, very difficult to find things to buy in the current market environment. And as we have discussed in the past, mutual fund managers cannot sit on large cash stockpiles.

This is the critical difference between an investor concerned with relative performance versus a benchmark index and an investor concerned with absolute performance that will compound capital at attractive rates over time. Ambitious absolute return goals should be accompanied by high return hurdles. When a hurdle is set at “bond yield + x bps” in a low rate environment it may underprice risk.

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