Allison's Ode to the Second Moment


Welcome to the 63rd issue of Allison’s Ode to the Second Moment, a newsletter that’s free, like all things that should come with a risk warning.

Passive Funds

I sometimes wonder if we’ve reached peak low fee. Last year, after years of trending down, asset management fees reached 0. It all started when investors found passive religion, and now even passive funds are under-cutting each other—fee-wise.

Of course, nothing in finance is really free, even diversification. Fund managers need to be paid some way, such as an enticement to use another high-fee product or lending your shares, which means you, the investor, take on tail risk in exchange for cheap or free elimination of idiosyncratic risk. But on balance, low fees are better for the world.

Some worry passive funds will undermine market efficiency because they are taking over the market (and by takeover I mean less than 20% of assets) and “smart” people aren’t picking stocks and allocating capital to its best use. Such people overestimate human nature. As long as markets exists, some people will think they can do better than the rest, and sometimes they will. Many of those people manage endowments and pension funds; it’s their job to be active and they aren’t going anywhere.

My one worry is that people will start to think diversification is a complete risk strategy and only judge funds based on the fees they charge. Don’t get me wrong: We should shop fund prices the same way we do any product. But it is also important to consider what the fund is invested in and your risk exposure. Passive funds are great for diversification, which eliminates idiosyncratic risk, but they don’t do much for systematic risk, which is the risk the whole market will drop. Managing systematic risk, either takes a good hedging strategy or insurance, and in both cases, that will usually cost something. With insurance, you pay someone to take on your downside risk—that will never be free—nor should it be, unless you want more systemic risk.

One risk I am not worried about is that passive funds increase market volatility. Seriously, we are just coming off historically low volatility markets while passive funds allegedly took over the markets. By historical standards, volatility is still reasonable.

Fed Independence

Speaking of volatility, it was a dramatic few weeks for markets. They went down, then up, down again, and back up. People blamed the volatility on many things: threat of trade wars, algorithmic trading, passive funds, Fed policy—you name it—everything, but this is what markets do. The S&P 500 has historically had a 20% annual volatility.

But one potential cause is troubling, the possibility that President Trump wants to “fire” Jay Powell. Suddenly, there were many solemn pledges from policy makers and pundits to protect another serious norm violation: Fed independence. Now, like any good Pension Geek, I think independent monetary policy is very important. Policy is often captured by short-term interests, such as the worry anyone’s 401(k) might lose a cent in the stock market. Effective monetary policy takes credibility, the Fed must balance the long- and short-run health of the macro economy and financial markets. Sometimes long-term health requires short-term pain (like jogging). At the AEA meetings this year, Ben Bernanke called well-anchored inflation expectations a capital asset. This asset enabled him to undertake extraordinary policies to boost the economy without sparking runaway inflation. But we must preserve that capital asset, and that takes credibility and independence.

Threatening to fire the Fed chairman over non-zero real rates is bad. But I am wary of many who just joined the Fed’s independence train. If someone says, “I agree the Fed should be independent, but the President is not wrong, just look what happened to the stock market after a pre-committed, quarter of a point rate hike,” we might want to doubt this is a reliable Fed independence ally.

Working in Retirement

Working longer is one of the best ways to finance a retirement. In a knowledge economy, working past retirement age is now possible for more people. But there’s a problem.

Pro Publica and the Urban Institute released a troubling report. They crunched HRS data and estimate that 56% of Americans over 50 will be forced out of a job, have problems finding another, and probably face a pay cut. Everyone faces this risk regardless of education and industry. It is a bad time for a pay-cut and unemployment; post-50s is normally peak earning years and it is when many people get serious about retirement saving. It is also just a terrible waste of skill and talent. Age discrimination is a serious market failure. We moved from a DB world where employers controlled when their workers quit (with vesting rules) and retired (with the benefit formulas). Now that employers don’t offer pensions, they are forcing workers out on less favorable terms.

One possible solution is more part-time and gig work instead of retirement. The possibility of different sources of income means less stress on late-middle-aged people. It is also less of a finanical strain on employers reluctant to hire older, more expensive, workers.

Teachers Quit

Speaking of defined benefit plans keeping people in a job—or not—teachers are quitting their jobs in response to low pay and under-funded schools. The Wall Street Journal reports teachers are paid 5% less now than they were in 2009. Their wages lag behind their private-sector counterparts. But these estimates do not seem to include pension benefits. Pensions are income for life, essentially risk-free. The long-term interest rate is also 15% lower, which means the pension benefits are more valuable than they were in 2009. Private-sector workers don’t get such generous retirement benefits; it is hard to say teachers are worse off.

But the quitting suggests teachers prefer higher pay today to more valuable pensions. Perhaps a solution could be moving new teachers to 401(k)-type plans and paying them more. It is cheaper for taxpayers, the governments, and teachers can make a living—though their retirement may be more spare.

Until next time, Pension Geeks!