Is the system rigged? If so, is this the end of volatility?

Axel Merk explores those questions in this guest post.

Fake Risk, Fake Return?

With seemingly everyone from the blogosphere to the Tweeter-in-chief chiming in on fake news, have investors considered their risk/return profile may also be “fake”? When it comes to investing, who or what can we trust, is the market rigged, and why does it matter?

For eight years in a row now, an investment in the S&P 500 has yielded positive returns [2015 assumes dividends reinvested]. In recent years, expressions like “investors buy the dips” and “low volatility” have become associated with this rally.

In the “old days”, investors used to construct portfolios that, at least in theory, provided a risk/return profile that they were comfortable with. For better or worse, I allege those “old days” are over. To be prepared for what’s ahead, let’s debunk some myths.

The system is rigged

For those that say the system is rigged, I concur. In my assessment, central banks are largely responsible for a compression of “risk premia.” All else equal, quantitative easing and its variants around the globe have made assets from equities to bonds appear less risky than they are. This is at the very core of central banks efforts to entice investors to take risks, as risk taking is key to making an economy grow. In practice, central banks have foremost pushed up financial assets, but have largely disappointed in generating real investments. As a result, those holding financial assets have disproportionally benefited.

Hidden risks: liquidity

When I look at market risks, I feel like investors are in ‘la la land,’ ignoring the moonlight. Pardon the pun, I believe investors completely underappreciate hidden risks in the markets, notably the risk of liquidity evaporating. In today’s ETF driven world, to make ETFs track underlying indices, there are so-called market makers providing liquidity. Exchanges are providing incentives to these market makers; ever look at those exchange fees on your trade ticket? The exchange pays market makers from these fees for each share they buy or sell (ranging from fractions of a cent to multiple cents); such a “rebate” gives market makers a better price than you can possibly get, so they can cost effectively hedge their own risk, thus incentivizing them to provide liquidity. Each ETF has a so-called lead market maker that, by arrangement, gets a better deal than the other market makers. Through that, all the other market makers know they can always offload their risk to the lead market maker. Everyone is happy, including the investor. Except when the lead market maker has a glitch. Suddenly, just about everyone withdraws liquidity because something appears wrong. In addition, Dodd Frank discourages traditional market makers to provide liquidity. Flash crashes can then occur when investors place market orders in the wrong belief that the system will take care of them. As a result, in our opinion, the current design of the system makes the periodic flash crash a near certainty.