During my recent conversation with Peter Kraus, which was supposed to be focused on Aperture and its launch of the Aperture New World Opportunities Fund, I couldn’t help veering off into tangents about the market in general. Below is Kraus’ take on the availability of alpha generation, the Fed, inflation versus Amazon, housing, the cross-ownership of U.S. equities by a few huge funds and high-frequency trading.
Gregg Schoenberg: Will alpha be more available over the next five years than it has been over the last five?
To think that at some point equities won’t become more volatile and decline 20% to 30%… I think it’s crazy.
Peter Kraus: Do I think it’s more available in the next five years than it was in the last five years? No. Do I think people will pay more attention to it? Yes, because when markets are up to 30 percent, if you get another five, it doesn’t matter. When markets are down 30 percent and I save you five by being 25 percent down, you care.
GS: Is the Fed’s next move up or down?
PK: I think the Fed does zero, nothing. In terms of its next interest rate move, in my judgment, there’s a higher probability that it’s down versus up.
GS: Why?
PK: Because the economy is actually slowing down and/or is potentially declining. In the rest of the world, growth is definitely a challenge. You have political controversy in Europe, and you’re going to have it here in two years, if you don’t have it now. Also, we are 10 years into this expansion. To think that at some point equities won’t become more volatile and decline 20 percent to 30 percent… I think it’s crazy.
GS: What do you think keeps Fed governors awake at night?
PK: Their biggest fear, what they lose their lunch over, is deflation. If the Fed makes a mistake and leaves interest rates low and inflation takes off, the Fed can handle that. What it doesn’t have the tools to deal with is if we get into a deflationary spiral. That is a problem. QE maybe is the way to solve that, but with a $3.8-trillion balance sheet, how much more can you solve?
GS: We could become Japan. Do you think you’ll live to see the day when the Fed buys equities?
PK: I already saw the day where the Fed bought equities. 2008.
GS: That’s very funny and true, but I meant directly.
Passive investing has obviously grown, but in terms of corporate actions and voting, they did no independent analysis.
PK: No. I don’t think the Fed needs to buy equities. Let’s take a step back. Why is unemployment at 3.8 percent and inflation so low? Why does the Phillips curve not work anymore? There are not a lot of good answers, but one potential answer is the effect of sharing assets — whether sharing your car, house or something else — and/or the effect of people becoming more productive because they’re buying things on Amazon and they’re not taking off of work to go to the store. The impact is much bigger than what can easily be measured. How much longer does it last? Amazon, of course, is going nowhere, but its marginal impact is—
GS: —The economy will ultimately adjust to that new reality.
PK: Yes, the marginal impact may not be as great. But getting back to the Fed, its big problem is in asset values. It’s not in the traditional inflation we’ve been measuring; it’s really in the value of assets.
GS: That’s why I asked you the question about the Fed buying equities, because if ultimately asset values are what’s driving overall economic health, then the Fed’s levers—
PK: —Yes, but people generally are not spending based on their equities. They’re spending based on their houses, their real estate. That’s a bigger piece of our economy, and the Fed dropping interest rates props that up.
GS: Moving on to another important topic, do you think it’s a problem that a small cadre of big index funds essentially owns a huge chunk of most S&P 500 companies?
PK: From what perspective?
GS: That a handful of institutional managers like BlackRock, Vanguard and State Street theoretically have significant horizontal influence over governance and decisions made by most big, public names.
PK: I think you need to remember the history of how we got here. Passive investing has obviously grown, but in terms of corporate actions and voting, they did no independent analysis.
GS: Leaning heavily on proxy firms like ISS and Glass Lewis.
PK: Well, to understand a corporate action, you need a PM or dedicated analyst to spend a lot of time with a company, the financials and the management. Does the passive infrastructure have enough money to support the army of analysts they’re going to need to actually perform that work? I don’t think so.
GS: So where does that leave us? You’ve seen some of the big passive players advancing a more socially conscious message as of late.
This is my ‘get real’ speech. Look, I watched people trade at five cents. The cost of having a high-frequency trader is de minimis.
PK: Like “we’re against bullet manufacturers.” Yes, they talk about doing good things, but what’s the real infrastructure underneath that analyzing whether that’s a good thing or not? In order for them to actually have an impact, they need to have the intellectual horsepower behind that, and so far as I know, they haven’t really built it.
GS: Is there any rationale for why HFT firms and proprietary traders should be allowed to co-locate at the exchanges?
PK: Yes. Listen, there’s a good and a bad. The bad is those high-frequency traders are performing a form of front-running. That’s the bad. What’s the good? They create enormous liquidity in the market, and the cost of trading is a now a fraction of what it was 30 years ago, and that is to the benefit of the client.
GS: Perhaps…
PK: This is my ‘get real’ speech. Look, I watched people trade at five cents. The cost of having a high-frequency trader is de minimis.
GS: You’re saying it’s de minimis from the value that they provide?
PK: Yes. Market structure is important, and I’m not suggesting that we should have front-running. It should be regulated; you need to watch it, and it can get out of hand. But what we’ve done as an industry, in terms of creating more efficiency and a lower cost of trading, is dramatic.
GS: Last question: Is capacity the main problem to generating alpha today?
PK: I think alpha has been drowned out by the scale and size of the industry. I’ve watched people produce returns for years, and I’ve watched them lose their returns for years as they got too big. I don’t care if you’re a hedge fund manager, private equity manager, macro manager, quant manager, active long-only manager, bond manager. I have watched all of them. Their incentives simply don’t stop them from controlling their capacity.
GS: Ha. Mo’ money, mo’ money.
This interview has been edited for content, length and clarity.