Curmi & Partners

Should you care about volatility?

By Somnath Banerjee

Let’s assume there are two investable bonds in the market. Both cost €100 today with a coupon of 5% per annum for ten years, paying €100 back at maturity.

Bond A is held by a buy-and-hold client base and there is very limited liquidity in it. Bond B is held by active investors and there is enough liquidity for it under normal market conditions. Let’s assume that in your mind the default risk on both bonds is almost negligible. Also, lets assume, both issuers have very similar fundamentals (financials, credit risk, expected cash flows etc.)

Which bond would you buy?

The answer lies in:

  • Whether you are an active or a passive investor; and

  • Behavioural finance.

The first point is quite straight forward. An active investor would like to trade her investments based on her changing views on market, whereas a passive investor won’t like to stress her with making investment decisions that often. Its like ‘Nah, I found a good investment that I like for ten years and I am not going to give myself a heart attack making those decisions frequently’.

Obviously, Bond A would have very little volatility as opposed to Bond B.

Passive investors argue that active ones underperform due to various reasons with the main one being cost of trading.

And they have been proven right especially in the past decade or so. The rise of passive style of investing (Exchange Traded Funds (ETF) etc.) has benefitted many purely because they charge clients in basis points (a basis point is 0.01%), whereas active managers (like hedge funds etc.) charge in percentage (hundred times more than a basis point).

The other reason passive investors cite against active investors is, arguably the excess return generating ability of active managers are at best debatable. The theory is in the long run very few active managers are able to beat the market consistently.

Now, I won’t go into that debate of stock picking abilities of active managers but is/are there are any downside(s) to passive investing?

It’s extremely naïve to imagine that even if the default risk of Bond A is the same as Bond B now, that will remain the same way for whole ten years. What if fundamentals of both company A and B deteriorates substantially? Clearly, active investors would sell Bond B and price will go down. But Bond A will hold its shape simply because passive investors will rationalize that even if the fundamentals of company A have gotten worse, they will still not default and hence there is no need to sell.

That’s where behavioral finance comes into play. There are two issues with this argument:

  • How sanguine passive investors can be that the company A wont default; and

  • What if some passive investors’ liquidity position deteriorates and they have no choice but to sell the bond in the market?

Imagine some fire sale going on in Bond A and the ruckus it will create for other bond holders. Suddenly even the HODL (Hold On to your Dear Life) investors have no choice but to mark to market their bond A position showing a gap down in valuation. That will suddenly cause balance sheet issues which in turn may have some serious consequences.

Lots of investment in the current market are passive investment like Private Equity etc., that specifically don’t do mark to market in the real sense.

Another big negative I see with passive investing is inefficient use of capital which in essence means keeping zombie organizations alive, which is counter-productive to the economy as a whole.

The risk becomes more pronounced in an environment where there is too much cash sloshing around in the system chasing limited investing opportunities. Human tendency is such that we will justify making dubious (read without analyzing all risks objectively) investments under pretexts, and not having enough investment opportunities is surely one of them.

It surely is enticing when one is getting returns without much volatility and looks great on paper, but one must give due consideration to the real possible risks originating out of illiquid/passive investments before venturing out on that path.