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.

The First Mutual Fund

Vereinigte_Ostindische_Compagnie_bond
Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Equity shares were scarce among the listed securities, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans, or negotiaties,as they were known in the Netherlands. Issued by merchant financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.

Expenses

The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.