Containing Competitive Monetary Easing

Raghuram Rajan

APR 28, 2014
Newsart for Containing Competitive Monetary Easing

MUMBAIAs the world struggles to recover from the global economic crisis, the unconventional monetary policies that many advanced countries adopted in its wake seem to have gained widespread acceptance. In those economies, however, where debt overhangs, policy is uncertain, or the need for structural reform constrains domestic demand, there is a legitimate question as to whether these policies’ domestic benefits have offset their damaging spillovers to other economies.

More problematic, the disregard for spillovers could put the global economy on a dangerous path of unconventional monetary tit for tat. To ensure stable and sustainable economic growth, world leaders must re-examine the international rules of the monetary game, with advanced and emerging economies alike adopting more mutually beneficial monetary policies.

To be sure, there is a role for unconventional policies like quantitative easing (QE); when markets are broken or grossly dysfunctional, central bankers need to think innovatively. Indeed, much of what was done immediately after the collapse of US investment bank Lehman Brothers in 2008 was exactly right, though central bankers had no guidebook.

But problems arise when these policies are extended beyond repairing markets; the domestic benefits are at best unclear when economies are deeply damaged or need serious reform, while the spillovers from such policies fuel currency and asset-price volatility in both the home economy and emerging countries.

Greater coordination among central banks would contribute substantially to ensuring that monetary policy does its job at home, without excessive adverse side effects elsewhere. Of course, this does not mean that central bankers should be hosting meetings or conference calls to discuss collective strategies. Rather, the mandates of systemically influential central banks should be expanded to account for spillovers, forcing policymakers to avoid unconventional measures with substantial adverse effects on other economies, particularly if the domestic benefits are questionable.

For a long time, economists had converged on the view that if central banks optimized policies for their domestic situation, coordination could offer little benefit. But central banks today are not necessarily following optimal policies – a variety of domestic constraints, including dysfunctional domestic politics, may prompt more aggressive policies than are strictly warranted or useful.

In addition, cross-border capital flows, which increase economies’ exposure to the effects of one another’s policies much more than in the past, are not necessarily guided by economic conditions in recipient countries. Central banks, in an effort to keep capital away and hold down the exchange rate, risk becoming locked into a cycle of competitive easing aimed at maximizing their countries’ share of scarce existing world demand.

With a few rare but laudable exceptions, officials at multilateral institutions have not questioned these unconventional monetary policies, and have largely been enthusiastic about them. This approach carries two fundamental risks.

The first hazard is a breakdown of the rules of the game. Endorsing unconventional monetary policies unquestioningly is tantamount to saying that it is acceptable to distort asset prices if there are other domestic constraints on growth.

By the same token, it would become legitimate for countries to practice what they might call quantitative external easing” (QEE), with central banks intervening to hold down their exchange rates, while building huge reserves. If net spillovers do not determine internationally acceptable policy, multilateral institutions cannot claim that QEE contravenes the rules of the game, regardless of how much instability it engenders.

In fact, this is no mere hypothetical. Quantitative easing and its cousins are implemented primarily in situations in which banks are willing to hold enormous quantities of reserves unquestioningly typically when credit channels are blocked and other sources of interest-sensitive demand are weak. In such situations, QEworks,” if at all, primarily by altering exchange rates and shifting demand between countries. In other words, it is different from QEE in degree, not in kind.

The second danger is that source countries’ unwillingness to take spillovers into account causes unintended collateral damage in recipient countries, prompting self-interested action on their part. Even as source-country central banks have painstakingly communicated how domestic conditions will guide their exit path from unconventional policies, they have remained silent about how they would respond to foreign turmoil.

The obvious conclusionreinforced by the recent financial-market turbulence that followed America’s move to exit from more than five years of QE – is that recipient countries are on their own. As a result, emerging economies are increasingly wary of running large deficits, and are placing a higher priority on maintaining a competitive exchange rate and accumulating large reserves to serve as insurance against shocks. At a time when aggregate demand is sorely lacking, is this the response that source countries want to provoke?

Despite the evident benefits of expanding central banks’ mandates to incorporate spillovers, such a change would be difficult to implement at a time when domestic economic worries are politically paramount. A more practicable solution, at least for now, would be for source-country central banks to reinterpret their mandates to consider the medium-term effects of recipient countries’ policy responses, such as sustained exchange-rate intervention.

Central banks could thus recognize adverse spillovers explicitly and minimize them, without overstepping their existing mandates. This weaker form of “coordination” could be supplemented by a re-examination of global safety nets.

The risks generated by the current non-system are neither an advanced-country problem nor an emerging-economy problem. The threat posed by competitive monetary easing matters to everyone. In a world with weak aggregate demand, countries are engaging in a futile competition for a greater share of it. In the process, they are creating financial-sector and cross-border risks that will become increasingly apparent as countries exit their unconventional policies.

The first step to prescribing the right medicine is to recognize the cause of the illness. And, when it comes to what is ailing the global economy, extreme monetary easing has been more cause than cure. The sooner we recognize that, the stronger and more sustainable the global economic recovery will be.

Raghuram Rajan is Governor of the Reserve Bank of India.

April 27, 2014 3:05 pm

America’s compulsive urge to regulate

With its spider’s web of local and federal rules, the US is swinging back to intrusion

US uniformity©Matt Kenyon

Americaso the song says – is the land of the free and home of the brave. It does not always feel that way. Last week the Food and Drug Administration said it would regulate e-cigarettes like normal tobacco. This is in spite of the fact there is no proof it leads people on to the real ones. Quite the reverse – the whole point is to help people kick the habit

Chicago, Boston and Los Angeles have gone further and banned e-cigarettes in public places. There is no evidence their vapour causes harm to users or bystanders. The sight of it alone is apparently offensive enough.

The US has always struggled between its impulse for freedom and a Calvinistic urge to meddle. The pendulum in early 21st-century America is swinging back to intrusion. Whether it is workplace safety, traffic, public health or social behaviour, there is a creeping impulse to micro-regulate.

Far from the freedom of the open road, today’s US offers a spider’s web of local and federal rules. Fancy bicycling without a helmet or unleashing your dog? Or perhaps opening a can of beer on the beach? There is an ordinance forbidding it. New York is trying to ban 16-ounce soda. Singapore’s Lee Kuan Yew would not feel out of place in Rahm Emanuel’s Chicago. Sugar is the new tobacco, we are told. How soon before we get to caffeine?

The fashion for paternalism is driven by a growing culture of conformity. Some of it is driven by demand. More than three generations after the Great Depression and the second world war, and almost two generations after Vietnam, there are few Americans alive who remember how hard life once was. Words such as thrift and rugged have dropped from everyday speech. People’s understanding of what is risky has expanded sharply while their resilience to setbacks has fallen

University administrators talk about “tea cupstudents, who are so fragile they shatter easily. College freshers are so used to getting pass grades in high school for mediocre work many cannot handle the shock of accurate marking. Almost half of US college students fail to complete four-year degrees in six years.

Some of it is also driven by supply. In a labour market, where people are increasingly competing with machines for jobs, there is waning tolerance for antisocial behaviour. Employers routinely scrutinise an applicant’s online history, as well as conducting the more traditional drug tests and criminal checks. Daniel Patrick Moynihan, the great US senator, once complained that America was “defining deviancy down”. That trend has gone full throttle into reverse.

Hordes of American children apparently now suffer from some kind of mental condition. Ten per cent are diagnosed with attention deficit disordertriple the level of 20 years ago. Many such diagnoses are surely authentic. And perhaps ADD used to be underreported. But it is hard to believe it has suddenly taken off

There was a time when chronic fidgeting in class got you detention. Now it is medicated with Ritalin. In 1992, one in 500 American children were diagnosed as autistic. Now it is one in 68. Prescriptions have rocketed.

The same applies to adults. Last year the American Psychiatric Association produced its latest Diagnostic Manual of Statistical and Mental DisordersDSM5, as it is known. It is the psychiatrist’s bible. Among the recent conditions is Social Anxiety Disorderotherwise known as shyness. Twelve per cent of Americans get SAD at some point, for which the helpful folk at GlaxoSmithKline prescribe Paxil. Other disorders include “hypersex”, “hoarding” and “bereavement”. Some psychiatrists believe there is an epidemic of anxiety in the US. That may be so life can be stressful in the internet age. Far more likely, however, is an outbreak of diagnostic inflation.

Some of it can be blamed on the drugs companies, who bombard doctors with freebies. They also advertise directly to teachers and parents. But a great deal can be blamed on the widely held belief that every wayward emotion is the result of some chemical imbalance – and can thus be reversed by medication.

Many Americans – and not just those who support the Tea Partychafe against suffocating regulations and the trend to “polypharmacy”. Liberty or death” is a patriotic rallying cry. “Don’t tread on me” is another. Among the millennial generation there is rising support for libertarianism. And among Americans of all age groups there is growing support for gay marriage, legalised cannabis and even atheism. Freedom is a paradox. There are parts of America where it is difficult to smoke anything except for marijuana.

But the march of liberty is not a one-way street. Beneath the battles against racism and for sexual freedom, there is a deeper pull to conformity. What may once have been seen as eccentric is now liable to penalty, or prescription. Allen J Frances, a leading critic of DSM5, who headed the task force that produced an earlier manual, puts it well: “We are homogenising our crops and homogenising our people. Big Pharma [is] pursuing a parallel attempt to create its own brand of human monoculture.”

Compared with many democracies, America no longer feels unusually free. Psychiatrists keep turning up new forms of “dysregulatedbehaviour. Legislators keep drafting regulations to address them. People’s tolerance of disorder is falling, as is their resilience to shock. Feeling unusually human today? There is a pill for that

There might even be a law against it.

Copyright The Financial Times Limited 2014.

Barron's Cover

The New Indexing

Index investing is now an umbrella term for strategies with elements common to active management.

By Reshma Kapadia

April 5,2014


Index investing is in the midst of an identity crisis. When John Bogle launched the first index fund 38 years ago, it was intended as a common-sense, cheap way for individuals to invest in stocks. The Vanguard 500 Index was not intended to beat the market, but simply ensure investors didn't get left behind.

A lot has changed since the mid-1970s, and index investing has morphed from an oft-criticized novelty to the strategy of choice for countless individual investors, financial advisors, and institutions. Index funds themselves have undergone an even more radical change -- so much so that the meaning of "index" has been stretched to the point of incomprehension.

Thomas Reiss for Barron's

Indeed, index investing has become so popular that an entire industry has emerged, borrowing the term "index" and its accompanying halo of investor-friendliness as an umbrella term for a variety of strategies that have much in common with active management. Call it clever marketing, dismiss it as semantics, or express outrage at the word's corruption, but the term "indexing" simply doesn't mean what it once did. So much so that this renaissance of so-called indexing sets up investors with a complicated array of products, many of which carry higher costs and aggressive bets, and require a lot more scrutiny.
The first indexes -- the Dow and the S&P 500 -- were designed to measure and represent the broad market more tan 50 years before they became investible via mutual funds. Over time, other indexes were created to represent more specific parts of the market -- particular sectors, companies of a certain size, other asset classes, and foreign markets.

Today, though, indexes are not so much about measuring the market, as they are about beating it. Most new indexes these days are created with the sole purpose of building an investment product around it. "Now it's about doing better than the market," says Ben Johnson, director of passive funds research at Morningstar. "We have gone from the realm of benchmark creation to the realm of fabricating investible strategies."

Small wonder, given the money at stake: As of the end of February, 372 index funds managed nearly $1.8 trillion in assets, more than double what was invested in 2008, according to the Investment Company Institute
That doesn't even include the rise of exchange-traded funds in that time -- an industry that now commands $1.7 trillion in nearly 1,300 funds linked to some kind of index, more than three times 2008 levels
All index funds, by definition, are passive investments. There's no manager making trading decisions; all buying and selling is done according to a strict set of rules. Traditional indexes were designed to represent the market and serve as a benchmark, and as such they typically weighted stocks or other securities by size -- the stocks with the biggest market value or the largest amount of debt made up a larger portion of the index. These new "smart" index funds -- called smart beta, strategic beta, fundamental, alternative, advanced, enhanced, and probably a few other monikers -- veer from the market-value orientation. And that doesn't sit well with purists. "Market capitalization is the market consensus; if you believe you can do better by not following that view, that's a judgment call," says Joel Dickson, senior investment strategist at Vanguard. These funds are "blurring the lines by putting active bets into the index construct. It's the co-opting of the term indexing."

MOST OF THESE NEW INDEXES are packaged as exchange-traded funds -- some 350 ETFs versus just 47 mutual funds -- but this is not a product war. It's a matter of strategy, and, to an extent, semantics. But whatever you call this new breed of indexing, they all have one thing in common -- they turn the conventional wisdom of indexing on its head.

Today's alternative index funds apportion their holdings according to a host of factors other than market value in an effort to beat the market and boost diversification. Many take fundamental metrics such as cash flow and dividends into account; others look at volatility, some use a combination.

Some of these funds have beaten traditional index funds in recent years. But most have yet to be tested through a full economic cycle, and all require more effort in determining how to use them in a portfolio. "You have to be willing to be contrarian and underperform for periods of time -- sometimes years," says Chris Brightman, head of investment management at Research Affiliates, a pioneer in alternative indexing.

The argument for alternative indexing is compelling: By weighting securities by market value, the index tends to overweight larger stocks, which may be overvalued, and slight those that are smaller and have lagged. It also can result in a concentrated portfolio -- like when Apple got so big in 2012 that it made up 5% of the S&P 500. "You think you are holding something neutral but are instead holding a tilt to large-cap and growth stocks," says Lionel Martellini, a finance professor at European business school EDHEC. "Research has shown that it is the wrong tilt; value and small-cap stocks have a higher return."

That resonates with investors. Fund consultant Towers Watson's institutional clients doubled investments in these alternative index strategies last year to about $11 billion. Advisors say they are using these alternative index funds as a complement to traditional index funds, often using them to replace actively managed funds

Retail investors are pouring money in, with $82 billion -- or a quarter of all flows into ETFs and index funds last year -- going into funds that Morningstar identifies as strategic beta. In total, there is $563 billion in what Morningstar loosely calls strategic beta.

The most popular alternative index funds come in three iterations -- those that equal-weight securities, those focused on volatility in hopes of a smoother market ride, and fundamental indexing, which chooses companies according to their financial strength, using metrics such as sales, cash flow, book value, and dividends.

Towers Watson consultant Fabio Cecutto favors broad versions of these strategies -- a low volatility fund for all U.S. stocks, for instance, or a fundamental strategy that uses multiple metrics, since each has its shortcomings. Perhaps the most important trait, however, is cost -- transaction costs can be higher since alternative index funds trade more than traditional ones. And annual expenses can be higher, too: The average expense ratio for strategic beta ETFs was 0.49%, according to Morningstar, five times higher than some of the biggest broad-market index funds, though less than active management. Yet some ETFs charge double that

To sort through the pros and cons of alternative indexing, Barron's talked to analysts and fund consultants to find funds that represent the still-evolving alternative indexing world.

THE SIMPLEST VERSION of alternative indexing is equal weighting, an approach EDHEC's Martellini describes as "a very safe and natural starting point" for better diversification. It works just as its name implies; every member represents the same percentage of the index. An equal-weighted S&P 500 fund, such as the Guggenheim S&P 500 Equal-Weight RSP ETF (ticker: RSP) or the Invesco Equally-Weighted S&P 500 fund (VADAX), dramatically reduces the impact of the 50 largest stocks, which have a 97% correlation with the S&P 500's returns. An equal-weight approach has an 84% correlation with the S&P 500. These funds typically have more smaller companies and tend to be more volatile than the benchmark indexes, moving higher when the market is on a tear, and falling further when it is tumbling.

As a result, the Guggenheim S&P 500 Equal-Weighted ETF's turnover is four times that of the S&P 500, but over the past decade it has beaten the index by two percentage points annually. While the $2.4 billion Invesco fund has a distressing 5.5% front-end fee, it's an option for those who prefer a mutual fund; it has beaten the S&P 500 by an average of four percentage points annually over the last 15 years, according to Morningstar.

The same approach can work with commodities. Most market-weighted indexes rank commodities by economic size, leading to a heavy helping of energy. For a more diversified fund, Michael Conway, head of Conway Wealth Group at Summit Financial Resources, favors the $350 million GreenHaven Continuous Commodity exchange-traded product (GCC), which allocates equal amounts of money to 17 commodities. The result is one of the biggest allocations to agriculture among diversified funds and lighter oil exposure, which can damp volatility. The fund is structured as a commodity pool, which triggers extra tax steps, and it rebalances daily, which adds to trading costs. But over the past five years, the fund has beaten its equal-weight benchmark by 1.4 percentage points a year and ranks in the top 40% among all of commodity funds.

FUNDAMENTAL INDEXING IS what's most commonly meant when talking about alternative indexing. Much of their popularity stems from the success of the fundamental indexes created by Wisdom Tree and Research Affiliates. The latter manages $121 billion, with firms such as Pimco, Schwab, and PowerShares licensing its indexes, and its founder, Robert Arnott, has emerged as the new face of indexing. Executives at Research Affiliates have kind words for Bogle, but call the old definition of indexing "antiquated."

Research Affiliates' funds often have a small-company or value tilt, but can look very different than their actively managed counterparts. The $3.6 billion Schwab Fundamental US Large Company Index (SFLNX), for instance, weights securities based on cash flow, sales, dividends, and stock buybacks, which means it tends to hold more technology companies than traditional large-company value funds. The fund also adjusts sales downward for debt-laden companies, which means fewer financial-services companies than the average value fund.

Over the last five years, it has returned an average of 24% a year, putting it in the top 2% of Morningstar's large-value category, and besting the S&P 500 by about four percentage points. It's more volatile than a capitalization-weighted index, but less than most equal-weighted funds.

While not yet as common, fixed-income fundamental indexes make a lot of sense, as many people -- Bogle included -- believe the existing bond indexes are flawed and not representative of the investing opportunity, since the government owns so many of the bonds in the index. Plus, in a traditional bond index, the most indebted countries and companies -- often those in a weaker financial state -- get larger weightings. Fundamental indexes instead weight bonds based on economic measures, such as the ability of the country or company to pay its debt.

The biggest fundamental bond fund is the $648 million PowerShares Fundamental High Yield Corporate Bond fund (PHB). It takes less credit risk than funds tracking a traditional index, which means a lower yield and missing out on some of the upside. Over the last five years, it has returned an average of 12%, two percentage points less than the high-yield bond average, as lower-credit companies have done well in recent years.

LOW VOLATILITY FUNDS now have $11 billion in assets, thanks to investors' postcrisis skittishness coupled with a desire not to miss out on the bull market.

Though they've outperformed recently, investors should expect equal or slightly lower-than-market returns, but with less volatility, over the long run, Cecutto says.

As with all these funds, analysts stress the importance of looking past the broad concept to examine how the fund is rebalanced, according to what criteria, and whether there are any parameters. For example, the $3.8 billion PowerShares S&P 500 Low Volatility SPLV (SPLV) fund has no constraints limiting its sector bets, which can lead to heavy concentrations at times. Every quarter the index identifies the 100 lowest-volatility stocks based on the previous 12 months, and weights them accordingly. Its lack of sector constraints, says John Feyerer, vice president of ETF product management at PowerShares, makes the fund more agile and avoids areas that become too volatile. Over the past year, the nearly three-year-old fund has captured 68% of the market's rise and fallen about 10% less when it's declined, with a total gain of 13%.

If you're looking for a fund with more diversification, the iShares MSCI USA Minimum Volatility USMV  (USMV) does not allow for more than a 5% under- or overweight in a sector versus the benchmark index. The iShares fund has 8% in utilities while PowerShares has three times that. Its approach is a bit more complicated than PowerShares' fund, taking into account stock correlations, rather than just targeting those with the lowest volatility. "If it's a replacement for a core equity exposure, you probably don't want the sector risk, and would want a fund with constraints," says's Paul Britt, stressing that it really depends on what investors are using the fund for.

Over the past year, the fund has returned 13.6% compared with the S&P 500's 24.2% and 20.3% gain for Morningstar's large-value category. During the past year, the fund captured about 68% of the market's upside and acted as a buffer by falling 12% less than the market during declines.

When investors crowd into low-volatility stocks, as they've been doing in the past year, it can push valuations in some sectors, such as telecommunications, utilities, and consumer staples, to the point they become more volatile than usual.

That's a good reminder these alternative index funds still carry their share of risk, particularly when prices are higher. But Britt says overcrowding is less of an issue for long-term investors.

So it seems even these alternative index funds work best when investors buy and hold. Sound familiar