The Great Deflation Delusion | Chief Investment Officer

Worrying about deflation as an action itself, rather than a symptom of something else, will tie investors—and markets generally—in knots, according to Professor John Kay.

The economist and former chair of several academic institutions said inflation—and its counterpoint—were “no more than a reflection of the experience of people alive today,” in a column for the Financial Times.

“We could have been experiencing deflation for years without realising it.” —Professor John Kay“In 1913, unlike now, a pound or a dollar would have bought the same goods as a century earlier,” said Kay. “The longest semi-official price series we have reports a 140 fold rise in prices in the UK since 1750—but even then all the increase up to 1938 is accounted for by inflation during the Napoleonic and first world wars.”

While the price level roughly doubled during both these episodes, according to Kay, it fell slightly over the rest of the period. While this point of reference may serve to allay fears for those whose currency buys more today than last year, Kay advised against panicking.

For more stories like this, sign up for the CIO Alert newsletter. 

“With a commodity such as petrol, you can tell whether the price at the pump is rising or falling because petrol is a homogeneous product that changes little over time,” said Kay. “But what has been happening with cars, or smartphones, or medical services? In the [UK inflation measurement] the consumer price index (CPI), the price component for cars comprises the sticker price adjusted for changes in quality. Such quality adjustment is subjective — and, it is generally conceded, too low. So we could have been experiencing deflation for years without realising it.”

“In 1913, unlike now, a pound or a dollar would have bought the same goods as a century earlier.”Essentially, the central point is that the significance of a fall in a price index depends on the causes of that fall, said Kay, citing the declining price level in the second half of the 19th century as the result of rising manufacturing productivity and the opening up of new lands, particularly in North America.

Digital advancement and the rise of China as a financial superpower since the 1980s contributed in a similar way to the technological developments of the 1800s and shifts in global trade, said Kay. These events have combined to lead to inflation.

“On the other hand the deflation, and the associated depression and social strife, that Britain experienced between the world wars was largely the result of a misguided attempt to restore the 1914 exchange rate against the dollar,” said Kay. “Prices in Britain fell steadily after 1920 until President Franklin Roosevelt finally wrecked the gold standard at the London Conference on exchange rate stabilisation in 1933.”

Therefore, investors—and the markets in which they play—should be aware of what is causing prices to rise or fall and act accordingly.

“Raised body temperature might be a sign of fever or the result of a relaxing hot bath: it is wise to determine which it is before you start to worry, far less prescribe remedies,” Kay concluded.

The best hedge fund managers tend to be skillful security selectors, strong at sizing positions, and have high win/loss ratios, according to analytics firm Novus.

Identifying these three skills would help asset owners weed out the merely lucky managers, the firm argued in a report, instead picking ones with “precisely the skill they can rely on for future performance.”

Instead of looking at past returns alone, investors may be able to gather richer intelligence from managers’ holdings disclosures. Simulating portfolio returns based on reported positions would help investors understand how the manager made money, Novus advised.

“Once you know what you’re looking for, skill sets are not hard to identify,” said Stan Altshuller, the firm’s co-founder and chief research officer.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

The first skill—security selection—could be identified by isolating a sector of the market the manager participates in and comparing their performance versus a specific benchmark. Filter the search to only include managers with a significant exposure to the sector to find the top stock pickers, the firm advised.

A manager’s win/loss ratio, or the “ability to ride winners and cut losers,” was the second display of skill and indicator for future performance noted in the report.

“Some managers are masters at getting the most from their winning trades and cutting their losses in a timely manner,” Altshuller said. “The best managers in this category are outliers that exhibit huge win/loss ratios over time.”

And the most important skill of all, according to Novus’ research, is the ability to appropriately size security positions, which tend to significantly dictate over- or underperformance.

“This skill speaks to the conviction of the manager in their best ideas and an inherent understanding of relative value and risk control,” Altshuller said.

To spot managers skilled in position sizing, the report said investors can compare an actual weighted portfolio’s performance to an equally weighted model portfolio, leaving sizing as the only measurable difference between the two. (Except returns, of course.)

Novus added that while it is difficult to find hedge fund managers possessing all three skills, certain firms do stand out.

Between 2010 and 2014, Miura Global Management and Brenner West Capital—both based in New York City—came out on top in Novus’ analysis, with Boston-based PAR Capital Management following at third place.

Activist Carl Icahn’s firm Icahn Management also made the list at number nine.