The bizarre obession with interest rates

Is it laziness or stupidity?

It is hard to find a business show on television that doesn’t spend at least a few minutes in every interview speculating on whether the Bank of Canada or the U.S. Federal Reserve will start reducing interest rates this year and the making a prediction as to whether there will one, two, three or four rate cuts and, occasionally, one commenter or another will say there is a possibility of a rate rise. These people hold themselves out to be financial “experts”, often portfolio managers or amateur economists and sometimes stock brokers or private equity executives.

I rarely hear anyone speak about the fundamental issues that determine whether investors will benefit from reasonable long term returns and do so without having to pay an advisor or portfolio manager to “manage” their money. I feel like I am Alice in Wonderland.

A few basics to start. Bonds are contracts and an investor in a bond (also called a fixed income security) gets what they bargained for. Buy a bond and if the issue doesn’t fail, you get the interest payments you agreed to and on maturity you get your money back. That is the whole enchilada. Trading bonds based on a bet as to whether interest rates will fall and bond prices rise is a waste of time for investors as a group, since any gain enjoyed by one investor comes at the expense of another investor, since the die is cast as to how much interest and principal will be paid by the creditor who borrowed the money. The talking heads on BNN, Bloomberg, CNBC, MSNBC and Fox Business speculating on the direction of rates are parasites, eating up your returns with fees and commissions and encouraging you to abandon one holding in favor of another in a merry go round that does nothing that improves the profits of the underlying issuer of the securities you own. On balance, investors lose, advisors win, and financial intermediaries like brokerages and banks (and CRA or the IRS for that matter) collect money from the people that put the money at risk.

The conversation strays into first and second derivatives. Portfolio mangers will argue that if rates fall, earnings multiples on equities will rise and investors will see higher share prices. Why would they want higher share prices? To benefit, they have to sell the shares they own and get back on the merry go round to find some replacement investment. Higher share prices compel lower returns since if you pay more for the same earnings stream you will earn a lower return. Hello? Anyone think paying more will generate higher returns. Back to grade school for an arithmetic refresher for you.

Fundamentally and inescapably, the returns to investors as a class results from the operating results of the companies in which they hold securities. Trading reduces returns for investors as a class. If you are serious about investing, you avoid the fees and commissions charged by advisors, their firms and stock exchanges by buying out of favor equities in well-run companies at prices that promise a return on investment in the real world from a growing stream of dividends. No other approach can or will work for investors as a class, and while there are some investors who will do better than others by trading, as a group investors will earn less. Full stop.

Why fight City Hall?

Many ordinary people lack the skills to understand what the value of a given company may be and lack the time to acquire those skills, so they need advisors. But they don’t need advisors who pretend they can pick “winners” and “switch” between one holding and another to advantage. If you lack the skills to choose investments wisely, the emergence of index funds (Exchange Traded Funds or ETF’s which track a given stock market index) which have very low management expense ratios lets you take a position in a diversified selection of securities, but advisors will get into that field by pretending they have insight that for the time being suggest they think you should choose one industry or sector over another and trade between them. I think of Larry Berman, a staple of BNN Bloomberg, whose spiel on ETF’s and claims to be an ETF “expert” motivate me to switch channels.

For most retail investors, their best bet if they lack the knowledge and competence to choose securities is the Standard & Poor’s index ETF (ticker SPY) which tracks the major stock market index - the Standard and Poor’s 500 Industrials. Over many years, the S&P 500 index has returned an average of about 9-10%, not without ups and downs. Expenses are a tiny fraction of 1% (about 20 basis points) and the SPY passes n dividends on its holdings to holdings of the ETF which trade freely and are quite liquid. Eschew advisors, ignore “price targets” (no one is shooting), and buy a few units of SPY and take a vacation.

Most funds, virtually all portfolio managers, and most mutual funds do not produce results that “outperform” the S&P index and virtually none do so over any extended period.

The evidence is clear that long term returns on equities are better than fixed income and no major fund (e.g. pension funds) should put one dollar of the money set aside for beneficiaries in fixed income securities. This controversial claim was subject of a recent scholarly study called “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice by Aizhan Anarkulova, Scott Cederburg, Michael S. O'Doherty”.

The results triggered a plethora of critical articles defending what had become an age old paradigm that advisors had recommended for decades that pension funds should choosea 60:40 equity/fixed income allocation and the role of the committees overseeing the fund was limited primarily to varying the asset allocation plus or minus a few percentage points from the 60:40 mix. I am not surprised that portfolio managers who have touted the 60:40 approach for decades are defensive about their advice since acceptance of the conclusion that their advice cost funds millions exposes them to litigation risks. But the reality that a long term return that is only 100 basis points higher than the 60:40 default means enormous differences in 50 years, and social security and pension funds have longer horizons than 50 years.

Here is the difference in terminal value for a fund that returned 9% over 50 years and one that returned 10%.

Value of $1 million at 9% for 50 years = 1.09^50 = $74 million
Value of $1 million at 10% for 50 years = 1.1^50 = $117 million

This is a gross oversimplication since funds are both added regularly from contributions and withdrawn regularly from pension payments, but at its core it is an reasonable proxy for the outcome if 100% equities produced 100 basis points higher returns than 60:40 from a 9% base. Don’t think of this as a calculation of actual differences, but rather as a simple sensitivity test to illustrate the importance of long term returns over concerns over short term volatility in annual results.

Fraser Institute published a study on the long term return on monies managed for the Canada Pension Plan by the Canada Pension Plan Investment Board. Beneficiaries are unaffected by poor performance since CPP is a defined benefit plan backstopped by general revenues of the Canadian government so shortfalls in needed returns of the fund do not impact individual pensions directly but manifest themselves in indirect costs through taxes. The real rate of return on CPP investments for workers retiring in 2037 or later is an estimated 1.7%. The real rate of return on the S&P 500 over 150 years has averaged 6.9%.

Policy matters. Canadian pension funds are managed by professional advisors who dabble in fads like cryptocurrency tokens and cannabis based companies with a history of major losses. Yet some investors (often called “value” investors) have earned returns higher than market averages for decades. Peter Lynch’s Magellan Fund earned over 27% per year compounded for the fourteen years he managed that fund. Jim Simons’ Medallion Fund earned an average rate of return of 66% for 30 years. Warren Buffet and Charlie Munger’s Berkshire Hathaway earned an average return of 19.8% from 1965 to 2022. What they had in common was common sense. They rarely traded, based investment decisions on hard data and avoidance of unnecssary risk, and held positions for long periods. Simons was a mathematician, not an advisor, and based his investments on rigorous statistical analysis. A $1,000 investment in his fund at its origination and held for 30 years would have returned over $4 billion (if anyone other Simons actually did so).

The obsession of sell-side analysts, portfolio managers and advisors with changes in short term interest rates and cental bank policies is entirely directed to short term bets and short term trading, not long term returns on capital by issuers who generate the income that makes stocks valuable. It is a waste of time. Gains by one investors come at the expense of losses by another, and no new wealth is created except for those whose income is based on commissions and advisory fees which is parasitical to the returns of those whose money is actually at risk. I conclude it a combination of laziness and stupidity in about equal proportions.