How to evaluate investors in the era of government intervention

It’s becoming increasingly normal that government intervenes financial markets. On the last Thursday, the ECB finally joined the “QE club” and this announcement led higher stock price, lower interest rates and lower Euro, which is probably what the European policymakers wanted. While it’s tempting to just focus on macroeconomic impact of these intervention policy, one should not forget about an impact on investors’ behavior. In the ECB example, most of the discussions are about how QE policy works to get European countries out of economic stagnation, and only a few people seem interested in how the policy affects investors’ incentive.

Let’s say government intervenes particular market and the price of intervened asset keeps raising. While many investors think it’s might be a bubble, it’s not always the case that they sell that asset expecting their investment decision will be finally paid off when a bubble bursts. Why isn’t? One reason might be the fact that many investors are evaluated based on “excess return (alpha)”, not absolute return. In other words, they have to earn more than their benchmark (e.g. market indices of the asset class they invest) earns. This means that as long as the asset price keep raising, investors who go against the market keep making “loss” relative to their benchmark. And since their performance is often evaluated in short period of time, their best strategy to maximize their clients’ benefit could be just following the bull market, even if they know it’s a bubble.

There are two important implications drown by the example above. First, since some governments intentionally create market distortion based on their belief on how intervention can help to achieve their policy goal, we cannot just say “bubble is bad” in this era of government intervention. Second, when asset boom is going on, either buyer or seller of that asset is betting on their investment strategy, purely to maximize their profit just as they usually do. This also means that the investment strategy should be evaluated based on the investment performance, not from the “social welfare perspective”. Based on those arguments, I would disagree with the idea of “Betting against subprime mortgage loan was a good thing” in the recent blog post by Dean Baker.

As the recent episode of the Great Recession and aggressive policy response by the Fed and other US policymakers clearly depict, government intervention policy can help to achieve policy goals. However, it’s policymakers’ job to prevent excessive asset bubble driven by their policy. And we should evaluate investors by how much they earn, not by what they do for the society.

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