Really liked this line regarding MVO modeling: "Those inputs—expected returns, volatility, and correlations—are not objective truths. They are assumptions that, in practice, can be influenced by institutional incentives as well as underlying economics." Too many in the pension industry represent their Monte Carlo simulations based on those assumptions as crystal balls. In practice, it's often not hard to know the results in advance (at least at a high level) based on the assumptions.
And the incentives for public pension plans that use these assumptions include minimizing reported *liabilities* based on discounting projected pension benefit cash flows using expected portfolio returns instead of using (lower) discount rates that reflect the timing and credit risk of the liability cash flows as required under basic finance theory. Consultants whose assumptions and models don't justify high actuarial discount rates, as well as any actuaries inclined to apply finance principles in their discounting of pension liability cash flows, will likely find themselves excluded from the ~$6tr public pension industry. Between the consultants and the actuaries, it's not clear to me who the tail is and who the dog is. In any case, their incentives align.
Exactly correct. The rage to “prove” market and economic hypotheses through quantification of non-robust systems engulfed academia and has infected investing processes at most institutions. The financial history books are packed with discredited and destructive academic exercises that were promoted by consultants, adopted by major institutional investors and only abandoned after catastrophic failure. The academic literature around the “Nifty Fifty” mania is very instructive. Abandoned at the lows in 1974-5 to shift toward “liability matching” which promoting buying long term bonds right before their worst collapse of the century.
Hi Mark, I really enjoyed this read and the section on the Fed is particularly poignant as Consumer Prices rose to 3.8% in April from a year earlier due to ongoing conflict in the Middle East (energy prices). With easing likely off the table for now, it’ll be interesting to see the stance the Fed takes moving forward given the significant challenges they face (as you mentioned).
This was a big mistake, and contrary to most commentary it was absolutely known at the time. In August 2024, history strongly suggested that the risk of inflation reigniting far exceeded the risk of deterioration in labor markets. This was one of the most powerful lessons from the late 1960s and early 1970s. Jerome Powell was aware of this lesson, as were many of his colleagues, and they chose to ignore it in favor of data dependency. Now the consequences of failure are being felt, and the pain required to reverse the error has risen significantly. Just like it did in the 1970s.
I agree 100% with the thesis and disagree markedly with your application of it to private markets - which is a strong indication that we are in a realm of radical uncertainty. Very good article though!
Thank you, Ross. I appreciate the comment. I’d be interested in hearing which aspects of the application to private markets you view differently. My own concern is less about private markets existing and more about the combination of scale, structure, incentives, and liquidity expectations that tend to emerge late in cycles.
It's always about the incentives and as you point out, the ones driving the speculative supply chain. And if not the same ones as in previous episodes, they are more likely to escape the attention of the generals.
Exactly. This is why the post mortem is the most critical phase. The strong tendency is to villainize the most visible participant in the supply chain, which hides the fact that the formation of these supply chains is the real danger. My belief is that this is why history repeats.
Really liked this line regarding MVO modeling: "Those inputs—expected returns, volatility, and correlations—are not objective truths. They are assumptions that, in practice, can be influenced by institutional incentives as well as underlying economics." Too many in the pension industry represent their Monte Carlo simulations based on those assumptions as crystal balls. In practice, it's often not hard to know the results in advance (at least at a high level) based on the assumptions.
And the incentives for public pension plans that use these assumptions include minimizing reported *liabilities* based on discounting projected pension benefit cash flows using expected portfolio returns instead of using (lower) discount rates that reflect the timing and credit risk of the liability cash flows as required under basic finance theory. Consultants whose assumptions and models don't justify high actuarial discount rates, as well as any actuaries inclined to apply finance principles in their discounting of pension liability cash flows, will likely find themselves excluded from the ~$6tr public pension industry. Between the consultants and the actuaries, it's not clear to me who the tail is and who the dog is. In any case, their incentives align.
Exactly correct. The rage to “prove” market and economic hypotheses through quantification of non-robust systems engulfed academia and has infected investing processes at most institutions. The financial history books are packed with discredited and destructive academic exercises that were promoted by consultants, adopted by major institutional investors and only abandoned after catastrophic failure. The academic literature around the “Nifty Fifty” mania is very instructive. Abandoned at the lows in 1974-5 to shift toward “liability matching” which promoting buying long term bonds right before their worst collapse of the century.
Hi Mark, I really enjoyed this read and the section on the Fed is particularly poignant as Consumer Prices rose to 3.8% in April from a year earlier due to ongoing conflict in the Middle East (energy prices). With easing likely off the table for now, it’ll be interesting to see the stance the Fed takes moving forward given the significant challenges they face (as you mentioned).
This was a big mistake, and contrary to most commentary it was absolutely known at the time. In August 2024, history strongly suggested that the risk of inflation reigniting far exceeded the risk of deterioration in labor markets. This was one of the most powerful lessons from the late 1960s and early 1970s. Jerome Powell was aware of this lesson, as were many of his colleagues, and they chose to ignore it in favor of data dependency. Now the consequences of failure are being felt, and the pain required to reverse the error has risen significantly. Just like it did in the 1970s.
I agree 100% with the thesis and disagree markedly with your application of it to private markets - which is a strong indication that we are in a realm of radical uncertainty. Very good article though!
Thank you, Ross. I appreciate the comment. I’d be interested in hearing which aspects of the application to private markets you view differently. My own concern is less about private markets existing and more about the combination of scale, structure, incentives, and liquidity expectations that tend to emerge late in cycles.
It's always about the incentives and as you point out, the ones driving the speculative supply chain. And if not the same ones as in previous episodes, they are more likely to escape the attention of the generals.
Exactly. This is why the post mortem is the most critical phase. The strong tendency is to villainize the most visible participant in the supply chain, which hides the fact that the formation of these supply chains is the real danger. My belief is that this is why history repeats.
Thank-you for your insightful analysis, Mark.
Examination of the incentives that might sway an advisor's recommendations is always warranted.
I love your history-based analyses. History may not exactly repeat itself, but it often rhymes.
Great article man, actually interesting which is rare to find
Subscribed, would love to have you along too🙂