One of our favorite topics over the years has been observing the inversion of fundamental cause and effective, or rather, the reflexivity of synthetic, "passive" products such as ETFs and VIX, which in a normal world are driven by the value of their underlying securities, yet which in recent years have seen the direction of causality inverted, and where it is the value of the synthetic product that inluences the market price of its underlying constituents, or said simply, the "tail wags the dog." We have observed this phenomenon in both ETFs and VIX, the result of which has been even more confusion about whether fundamental causal links are even applicable any more.
This "inversion" is also one of the main points discussed by RBC's head of US cross-asset strategy, Charlie McElligott, who points out a recent FT article, and makes two stark observations.
FINANCIAL TIMES ON “…THE PERVERSE ECONOMIC EFFECTS CREATED BY ETF’s”: Two points:
- In a world of manic factor crowding via the exponential growth of cheap passive index and smart beta products, get ready for the class-action lawsuits in a future-state. And:
- this is BEYOND GOLD as an example of “tail wagging dog” / “echo chamber” / “feedback loop amplification” from the market structure shift experienced within the industry over the past 10+ years:
“Steve Bregman, president of Horizon Kinetics, the New York investment adviser, points out that ExxonMobil, the oil company, is included not only in S&P index products, but in ETFs for active beta, momentum, dividend growth, deep value, quality and total earnings.
Between the second quarters of 2013 and 2016, Exxon had a revenue decline of 46 per cent, and earnings per share decline of 74 per cent and a debt increase of 129 per cent, which led to a share price increase of 4 per cent. Anything could happen to the energy industry or Exxon's fortunes, but a liquid index component can only go up.”
Seriously…standing ovation. Citizen Kane style.
Fund Management: On the perverse economic effects created by ETFs (Financial Times)
By John Dizard
Oct. 10 (Financial Times) -- We have a consensus now in America that everyone deserves above-average investment returns, low risk and high liquidity.
These benefits, or rather, entitlements, should be delivered continuously at low cost, with no real or even apparent conflicts of interest on the part of portfolio managers.
If these benefits are not delivered, then the responsible portfolio managers, and any other complicit Wall Streeters, should be punished civilly and criminally, not only as institutions but as individuals.
If you think that is an exaggeration, wait until there is a severe or sudden decline in the value of equities, specifically exchange traded funds, and watch the consequent Congressional hearings. We still have some time before that happens, and before then every plausible form of indexed investing is going to take market share from active human managers.
I am opposed to this trend, because algorithms do not read newspaper columns or the advertising displayed next to them. So you should probably discount some of the doubts I raise as nothing more than arguments for my profession's interests.
The most serious risks arising from ETFs are the macro consequences of too much capital committed in too few places at the same time. The vehicles for over-concentration change over time, but the outcome is the same. Investors' cash goes to money heaven, and there is a pro-cyclical decline in productive investment.
Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. Since US growth stocks such as Avon, the cosmetics company, Polaroid, the photography group, and IBM, the computer company, outperformed the market, growth-orientated portfolio managers raised more money in the early 1970s, which then led to more cash going to buy the same stocks.
There was some truth at the beginning of those story arcs, and so it is with indexed investing. Many "active" managers who are really formulaic hacks charge a lot of money to create the same herding risks, and provide little, if any, value added in the form of considered and effective capital allocation or liquidity provision.
Since the August 2015 flash crash of some ETFs, the SEC, the US regulator, and Wall Street have paid a lot of attention to market-structure problems created or exacerbated by the funds.
There has been less analysis, though, of some of the perverse economic effects created by ETFs or other forms of indexation. Index sponsors need stocks with a large float-adjusted market capitalisation, so index managers have a structural bias to a short list of large-cap S&P 500 stocks.
Steve Bregman, president of Horizon Kinetics, the New York investment adviser, points out that ExxonMobil, the oil company, is included not only in S&P index products, but in ETFs for active beta, momentum, dividend growth, deep value, quality and total earnings.
Between the second quarters of 2013 and 2016, Exxon had a revenue decline of 46 per cent, an earnings per share decline of 74 per cent and a debt increase of 129 per cent, which led to a share price increase of 4 per cent. Anything could happen to the energy industry or Exxon's fortunes, but a liquid index component can only go up.
Mr Bregman says: "The normal valuation for a lapsed growth company might be 12 to 15 times earnings. But all of the companies at the top of the S&P 500 have a valuation of 22 to 25 times earnings. If the indexation money comes out of them, they would be driven 25 to 50 per cent lower, relative to the market."
Such an unwind in the indexation/ETF regime will have political as well as financial consequences. Wall Street's probable next regulators from the Senator Elizabeth Warren wing of the Democratic party will not take long to make an aggressive move on asset managers.
As one Democratic activist reformer says: "This is why it is so critical to have the right person as chair of the Securities and Exchange Commission. Even though there are critical differences between the large asset managers and the banks, [companies] such as BlackRock do control and manage crucial parts of the financial infrastructure."
If, or when, indexed product sponsors have to face the consequences on the other side of monetary easing and a rising market, there are a lot of nominally active but low-performing managers who will also lose market share. Automated or semi-automated portfolio management offerings will be there to pick up that business.
Reportedly, Interactive Brokers, the brokerage, via its Covestor subsidiary, will be offering a set of five strategies for automated portfolio management, rebalanced quarterly, for a fee of 8 basis points.
So how much more value are human portfolio managers offering when they charge a premium to those machines?