I read this very interesting summary by PIMCO of recent Markowitz paper: Markowitz, Harry M. “Market Efficiency: A Theoretical Distinction and So What?” Financial Analysts Journal, Vol. 61, No. 5, pp 17-30, 2005. Also presented at the 25th anniversary of the Q-Group, Fall 2006, Santa Barbara.

For those who do not have time to chew over equations it is a very intuitive explanation of what happens on financial markets these days. Leveraged investors (hedge funds) increase returns, which forces unleveraged investors (real money guys, central banks, public sector assets managers) to move to hold more risky assets (even those with really bad risk-return characteristics). So the fact that some investors are leveraged and some are not increases prices of risky assets and leads to potentially dangerous situation when fat tail event happens.

Eventually some investors realize they would be better off with leverage than with large allocation to risky securities. It would be interesting to square this conclusions with those comming from Caballero Asset shortages paper .