Submitted by Mike O'Rourke via Jones Trading, [6]
Stability Breeds Instability
Barron’s published a story today that was hard to pass up “ETF Assets Overtake Hedge Funds; Fisticuffs? Not So Much.” [7] Chris Dieterich the story’s author notes that during Q2 ETF assets under management rose to $2.971 Trillion overtaking the $2.969 Trillion in hedge funds.
[8]
Dieterich further explains that the relationship between the two asset classes is more collaboration than competition. ETF’s have largely been adopted as important investment tool of the Hedge Fund industry. At the risk of sounding repetitive it is important to acknowledge once again how this underlying theme applies to contemporary market environment.
The rotation from active to index/ETF has been a persistent trend for years. The chart below from the Investment Company Institute has been in our strategy presentations throughout most of 2015.
[9]
The chart illustrates the massive rotation out of actively managed mutual funds into index products. One can even see there was an acceleration of the trend as 2014 drew to a close. This is not an indictment of indexing, ETFs or those using these instruments. It is an indictment of the environment and policy that has created it. For the numerous retail and institutional investors who use these tools for investing (as opposed to trading) they have generally chosen to cede the valuation and stock selection aspect of investing. Instead, they have chosen exposure investing. Who can blame them, since the FOMC launched QE1 in late November 2008 the S&P 500 has compounded at an annual rate of 15.5% through the end of 2014. Even if one measures from the end of 2010 after the recovery commenced the compounded return is 13.1% and since the end of 2011 it is 17.86%. With a central bank following an asset inflation policy the flows are following performance. The Fed has unknowingly created winners and losers in the asset management business on a massive scale.
The asset inflation environment also creates a volatility vacuum. Volatility is necessary to keep markets honest and provide long term stability. An investor must truly believe in their investment and must have performed significant due diligence to have the confidence to ride out the volatility. The market that is not kept honest is the one where reckless behavior proliferates, because it works and is profitable. The most prominent example is the massive carry trading that occurred during the last tightening cycle. The short term borrowing was funded in the Asset Backed Commercial Paper market. Since Fed policy was predictable, carry traders were never kept honest. As spreads tightened and became less profitable they simply increased the leverage and risk. This created the artificial demand that led to countless pieces of securitized garbage being created. It was also case where Fed policy created artificial demand.
Policy has and continues to foster an environment where more and more investors are ceding stock selection, valuation and due diligence for the sake of exposure. This creates an environment where the median P/E moves north of 20. An environment where companies miss earnings and recover the lost ground in weeks. An environment where market performance is driven by multiple expansion. As market compounded at 18% since the end of 2011, earnings compounded at a rate of 5.5%. The lack of volatility means the market has not being kept honest. Be fearful of the environment where active managers and due diligence are traded for exposure - it means risk is on the rise. As we learned in 2007, one of the largest risks in the investing world is not simply the risk you are taking, but the risks those in the environment around you are taking.
