As ETFs Pass $1 Trillion In AUM, What Next?

Today's breach of the critical $1 trillion barrier by the Federal Reserve On/Offshore Genocide Opportunities Fund, LLC in its Treasury holdings is not the only important "trillion" milestone in the past few days. As was reported by the WSJ previously, total assets under management in the ETF space also passed $1 trillion for the first time ever, primarily courtesy of SPY, which added $11.6 billion (even as it continues to be the most shorted NYSE security in the world with 294.1 million shares short on 700 million total shares), and the IWM which saw $976 million in new assets. Granted, these numbers are just a little suspect, since according to the monthly Invesco PowerShares report, total ETF assets were still "just" $934.4 billion, but we will take Blackrock's word for it. And, considering that mutual funds, already at record low free cash levels, continue to bleed dry powder (32, and soon to be 33, consecutive weeks of outflows), and are saved from liquidations only due to levitating asset prices on this joke of a market which has absolutely no volume to it, many are trying to make the case that ETFs are rapidly becoming the next target of retail flows. Perhaps. Looking at the numbers this is certainly not as clear cut as those who specifically wish to see this, pronounce it as a fait accompli. Below we demonstrate that of the $96 billion in net flows YTD into various ETF styles, it is certainly not the case that equities are the pure beneficiaries of retail flows. That said, we present the thoughts of BNY's Nicholas Colas, who provides a useful reference guide on the history of the ETF business, and now that it has (allegedly) passed the trillion mark, looks at where the next trillion will come from (incidentally, it took the Fed four months to accumulate an incremental $250 billion in holdings; ETFs, on the other hand, as noted above, have seen inflows of $95.8 billion in all of 2010 - just wait until the Fed pulls a BOJ and starts buying the SPY openly instead of through Citadel).

First, we present the Year through November data per Invesco, which shows some materially different data than BlackRock:

Using simple math, which has still surprisingly not been made illegal by the government, nor has its borrow been pulled by State Street, when we subtract the contribution of foreign focused ETFs ($31.8 billion), and Fixed Income ETFs (31.1) billion, we get $32.9 billion. Then take out commodity funds, which invest in that damned gold thingy, which have seen $9.5 billion in inflows, global (non-US) specialty, currency and speculative leveraged ETFs, and you get a meager $15.5 billion. Compared to the $95 billion in outflows from domestic equity focused mutual funds YTD, and one can see why the numbers tend to not substantiate claims that ETFs are even close to replicating the retail desire for stock participation.

In other words, until we actually see a rotation from fixed income into equity products, we hope the peanut gallery can retain its enthusiasm until its claims are at least somewhat validated by facts.

And now that readers have been made aware of said facts, here is a primer on what may happen to ETFs, if all works out as expected, and the ETF asset class, which according to many (Zero Hedge certainly included), are nothing but synthetic CDO type instruments, whose operation in times of copious liquidity has been proven to be viable, yet which also according to many were instrumental in creating the forward feedback loops that were reponsible for the flash crash, an event which the market has forgotten so promptly that it is certain to recur as absolutely nothing has changed since then.

From BNY Convergex' Nicolas Colas:

The Judgment of Paris - Origins of the Next $1 Trillion in ETF Assets

Summary: Assets under management at domestically listed Exchange Traded Funds exceeded $1 trillion for the first time late last week, a notable event for this product. The inflows that put ETFs over the top were to traditional S&P 500 offerings, with SPY adding $11.6 billion and IVV posting $976 million in new assets last week. IWM (iShares Russell 2000) also saw inbound money flows, at $783 million. As the industry passes this important milestone, the logical question becomes, “Where does the next $1 trillion come from, and how long will it take?” There is little doubt that money chases performance, so the bedrock for significant growth is clearly a continuing move higher for risk assets. However, seven of the top 20 asset gathering ETFs over this year were fixed income/preferred offerings, meaning that any further back-up in rates will create a real headwind for this category. In the end we think the fundamental tug of war will be between increasing investor confidence (positive for assets) and larger asset bases at hedge funds, which tend to use ETFs on the short side (negative for asset growth).

I recently came across an article that referred to the “Judgment of Paris” and was surprised to read that this phrase evokes more than one meaning.

  • According to the ancient Greek myth, the goddesses Athena, Hera, and Aphrodite asked a mortal man, Paris, to judge which one of them was the “Fairest.” Translation to today: Jennifer Aniston, Angelina Jolie, and Heidi Klum ask some middle aged fellow off the street to decide who is “Hottest.” Each goddess tried to bribe Paris with a gift: Hera - political power, Athena – wisdom and success in battle, and Aphrodite – his choice of the most beautiful woman in the world. The ancients knew a bit about male psychology, because in the story Paris chooses Aphrodite. He then steals Helen, considered the greatest beauty of the age, away from her husband. Cue 1,000 ships and the Trojan War.
  • For wine lovers, the “Judgment of Paris” was a famous contest held in May 1976 in the City of Light. French wine experts did a blind taste test of several high-end French wines, comparing them to the best of California’s offerings. The New World vintages bested the French wines in every category. Going into the event, no one thought such an outcome was possible. Only the French correspondent for Time magazine was at the event – presumably it was a slow news day – and he got the oenophile scoop of the century as a result.

The world of money management has its own ongoing “Judgment” at the moment: is there further growth in the world of Exchange Traded Funds? The ETF industry celebrated something of a milestone last week, reaching $1 trillion in assets under management for the first time. The abandoned husband, to borrow from the ancient story, is the mutual fund industry. Consider the brief sketches of each type of investment below:

  • Mutual funds are still the 800 pound gorilla of the industry. Their popularity goes back to the 1980s stock market boom, and assets under management are $11.5 trillion for U.S. registered funds. They are still the investment vehicles of choice for domestic investors in important categories such as retirement planning (401ks, IRAs and the like). Stock funds hold almost half the assets, at $5.3 trillion, with money markets ($2.5 trillion) and bond funds ($2.2 trillion) the other popular fund types. Unlike the growth trend we noted earlier, however, mutual funds have yet to reach their old highs in terms of AUM, which was +$12 trillion in 2007.
  • ETFs are the new(er) kid on the block, their initial popularity stemming from the 1990s stock market rally. Even with AUM reaching $1 trillion for the first time last week, this product is still less than 10% of the size of the mutual fund complex. The weighting in ETFs skews towards equities more than mutual funds, with $736 billion in assets. Fixed income products weigh in with $136 billion, and commodity products at just over $100 billion.

Even with the continuing success of the product, I know from conversations with ETF sponsors and written commentary by industry watchers that there is some concern about the vectors for the next leg of industry growth. In my opinion, the ETF industry’s basic structure is sufficiently different from mutual funds that the issue is more complex than many may realize. Simple notions of investor confidence simply don’t tell the whole story.

First, mutual funds and ETFs differ in some important ways:

  • Incremental demand for mutual funds always creates new shares and new assets under management. This happens once a day, after the market closes as fund administrators and accountants tally up the day’s redemptions and purchases. “Long sales” are balances against “long buys” and the difference creates an inflow or an outflow of capital.
  • New demand for ETFs also nets out against share sales, but this happens in real time, and with one notable additional source of shares. ETF shares are also marginable – mutual funds generally are not – so supply can come from short sales as well as holders who own shares and wish to sell. Consider that the SPY has 294 million shares short as of last count. Those are shares that trade in addition to the approximately 700 million shares issued by the fund sponsor. Under unusual circumstances the shares short count can actually exceed shares outstanding, as I will shortly describe. ETF sponsors therefore monitor trading in their funds to ensure that daily activity does not disrupt the settlement process.

    There has been some controversy on this point in recent months, especially as a few smaller ETFs have outsized short positions relative to shares outstanding. I am the first to agree that the optics of that situation are poor, to say the least. For example, the XRT ETF, dedicated to retail stocks, has 63 million shares short and about 20 million shares outstanding. But the bottom line is that ETF issuers track share create/redeems and shares outstanding on a real time basis and are acutely aware that this issue exists. Could they get caught out in a fast moving market in a highly volatile sector? Perhaps. But those events seem to only occur in rapidly declining markets and any forced mass creation of ETF shares would provide billions of dollars of buyside orders for the underlying stocks in the ETF. In an odd way, therefore, the short ETF issue I describe here acts as a market stabilizer, though this phenomenon is as yet largely untested in real world conditions.

It is only a mild oversimplification to say that hedge funds tend to use ETFs on the short side and retail investors provide the net demand. I don’t have any hard numbers to prove that contention, mind you – just years of buyside and sell-side experience watching how these constituents use the products. Despite the name, many hedge funds are long-biased, searching for names to own – be it for 10 seconds, 10 minutes or 10 months. The other side of the trade is often an indexed ETF, with the difference in performance between the long individual stock position(s) and the short ETF meant to create the alpha (outperformance) of the investment. Wonder why that heavily shorted ETF I mentioned above happens to track retail stocks? That happens to be, along with technology, one of the most widely traded sectors among hedge funds.

Net new demand in this paradigm comes more from retail investors, looking for targeted, low cost investment vehicles. The primary types of hedge funds we can envision being structurally long ETFs are short-biased funds, who use the product in the same way as their long-biased brethren, but in reverse. The two exceptions are precious metals funds like gold sector market leaders GLD and IAU, which offer rock-bottom fees, and hedge funds that specialize in macro bets.

If you think that assessment is reasonable, then the continued growth in ETF assets is essentially a tug of war between hedge funds and retail investors. Here is the framework for that observation:

  • As retail investors grow more confident in a continued rally in risk assets, they will shift capital from cash to equity ETFs. Mutual funds have been laggingwith this constituency – there has not been a week of positive flows into U.S. equity mutual funds since May 2010, after all – but at some point even traditional mutual funds will see some pickup in retail investment.

    The one caveat in the near term is interest rates. The dramatic back-up in yields over the past two months will continue if markets either grow more concerned about the ballooning U.S. budget deficit or more optimistic about economic growth and/or worried about rising inflation. Seven of the top 20 asset gathering ETFs for the year were fixed income/preferred stock offerings, and this leg of the ETF growth stool could buckle if rates move much higher.
  • Growth in hedge fund assets dedicated to equity strategies is the other side of the growth coin for ETFs. As these investment vehicles increase assets to equity strategies, a portion of their short-side book will come from ETF short sales. This will come through as “supply,” dampening the demand for new shares.