Monday, March 20, 2017

The $3 Trillion Shift in Investing?

Frank Chaparro of Business Insider reports, There could be a $3 trillion shift in investing, and it poses a huge problem for mutual funds:
A dramatic shift is underway in the investment world.

Passive investment products like exchange-traded funds have hoovered up assets at a fast clip in recent years. US-listed ETFs saw $283 billion in net inflows during 2016, taking aggregate assets under management to $2.5 trillion, according to Citigroup.

Exchange-traded funds could gain a further $2 trillion to $3 trillion in assets in the next three to five years, according to a big report on the future of the finance industry from Morgan Stanley and Oliver Wyman.

Fee pain is coming

ETFs are cheaper and more transparent than mutual funds, while mutual funds have struggled for performance in recent years. As such, money has poured out of mutual funds and into ETFs over the past few years. That has forced mutual funds to compress their fees so that they can compete.

With ETFs set to see their share in the US market increase from 15% to 40-60% over the next ten years, according to Credit Suisse, fee compression in the mutual fund industry will likely continue. Morgan Stanley estimates that fees charged by active managers could shrink by more than a third in 2017.

That's not good news, because lower fees means less profit.

The irony

The price compression that has swept the mutual fund industry has forced money managers to come up with ideas to cut costs in order to save their bottom line. One such solution they've come up with is a bit ironic.

According to Morgan Stanley and Oliver Wyman, mutual funds are now using ETFs, the very funds that have contributed to price compression, to cut their own costs. By investing in ETFs, mutual funds are able to free up time to focus on "more complex alternative investments," the report said.

Here's Morgan Stanley and Oliver Wyman's explanation (emphasis ours):
"Asset allocators such as Outsourced Chief Investment Officers (OCIO) and Wealth Managers will account for a large proportion of this incremental demand as they increasingly use ETFs at near zero cost to source beta exposure, allowing them to focus their resources on high conviction managers or more complex alternative investments. However, looking beyond 2019, the emerging use of passive vehicles as an integral part of an active fund management strategy will be arguably the more significant dynamic. Currently, Mutual Funds have ~$0.5TN invested in ETFs, much of which is used for liquidity management. We estimate using ETFs rather than the traditional approach of holding individual stocks offers a cost advantage of 5-8 bps in large and mid-cap equities. As Asset Managers search for ways to deliver performance at lower costs, this may mean that mutual funds find themselves among the largest investors in ETFs."
The report concludes that mutual funds will potentially be one of the biggest drivers of growth for ETFs.
This dramatic shift in the investment world -- ie. the proliferation of exchange-traded funds (ETFs) -- is nothing new, it's been going on for years which is why I'm increasingly worried that we moved from the big alpha bubble which has popped to one giant beta bubble.

Don't get me wrong, ETFs are fantastic, for most people it's the best low cost way to invest and gain market/ sector/ thematic exposure and I actually believe not only in ETFs but also digital platforms (aka robo-advisors) that manage people's portfolios by diversifying ETFs and rebalancing the portfolios automatically every year or as needed based on some simple rules.

If you're young and starting to invest for your retirement, you should learn all you can about digital investment advice and how it can improve your portfolio. Even seasoned investors and high net worth investors can profit off these platforms but you need to understand the key differences between them in terms of fees and services they provide (for example, some offer tax-loss harvesting, some offer services catering to high net worth clients, others offer no mimimums, etc.).

I'm not going to go over the pros and cons of robo-advisors but they too have contributed to this surge in exchange-traded funds (ETFs) taking place in the investment world.

As far as mutual funds increasingly using ETFs to manage their portfolios, no surprise there as almost all of them are closet indexers charging high fees as they underperform the market. And then we wonder why there is a crisis in active management and why big and small pension funds are increasingly insourcing their public market assets.

Keep in mind what Ontario Teachers' CEO Ron Mock told me back in 2002 when I first met him in Toronto when he was in charge of the multi-billion hedge fund program: "Beta is cheap, we can swap into any bond or stock index to gain exposure to beta for a few basis points. Real alpha is worth paying for."

Unfortunately, real alpha is getting harder to find these days but the point Ron was making is that you don't want to pay fees to any hedge fund for something you can cheaply replicate or gain exposure to using derivatives (swaps) or exchange-traded funds (ETFs) which many retail and institutional investors (including hedge funds) use to gain market exposure.

Why so much focus on fee compression? Because we live in a low growth world where ultra-low rates are here to stay (never mind what you hear in the financial media) and returns going forward will be a lot lower than what we experienced in the last 20 years.

In this low growth/ low rate/ low return environment, fees matter a lot to institutional and retail investors because they detract from net returns (after fees are factored in).

Unfortunately for the financial industry, fee compression isn't a good thing. It's having a marked effect on employment trends as big banks and investment firms myopically focus cost-cutting using computers and artificial intelligence to replace everything from bank tellers to traders and portfolio analysts and managers.

The digitization of finance is breathtaking and very worrisome because a lot of high paying and low paying jobs are vanishing and the new jobs being created to support this new infrastructure will eventually be outsourced to India or elsewhere at a fraction of the cost.

Banks are ruthless. Sure, profits rose in 2016 and bonuses are up but that only tells you part of the story. The truth is the big guys at the top are making all the money, the lower levels analysts are seeing their bonuses rise a little and everyone else in the middle is getting squeezed, fired and replaced by computers and algorithms.

[Note: In foreign exchange trading where big banks still rake their clients, rookie traders are causing problems at crucial moments. So much for letting go of the experienced traders!]

Following the 2008 crisis, new regulations forced banks to increase the base salaries of their employees to keep them happy as they slashed bonuses. What this did is bloat the compensation of some higher level staff (like managing directors) who subsequently weren't incentivized to take risk on their books. It just wasn't worth it for them to take the risk and risk losing their job. A lucky few crossed the street to join their big hedge fund clients but there too, most employees are unsatisfied with their bonuses (but 'quant geniuses' made off like bandits).

This is why I hate looking at the average bonus on Wall Street published in an annual report from the New York State Comptroller's Office. It tells us nothing of what is happening to the bonuses at the very top levels, lower levels and middle and upper levels. They should break it down in a lot more detail than what is currently provided because like I said, it's the people at the very top making the bulk of the money. The lower levels where salaries are relatively low enjoyed a bounce in their bonus but a lot of middle and upper level jobs are vanishing at an alarming rate.

The world of finance is irrevocably changing. Intense competition, fee compression, cost-cutting and artificial intelligence are all trends that will continue in the foreseeable future, exacerbating rising inequality which is deflationary.

In their infinite wisdom to evolve and myopically focus on cost-cutting, big banks are cannibalizing each other and killing aggregate demand in the process, a trend that should worry all of us. Because once those jobs disappear, they are gone forever, never coming back.

But it's not just finance, computers are slowly taking over pretty much every job (click on image; h/t, John Graham of Arrow Capital Management):


Anyway, back to the $3 trillion shift in investing. Beta is cheap, beta is great, but when everyone is jumping on the beta bandwagon, choose your beta carefully or you risk being exposed to severe downside risk.

Given my views on the reflation chimera and the risks of a US dollar crisis developing this year, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength here (book your profits while you still can). The only sector I trade now, and it's very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now.

I still maintain that if you want to sleep well, buy US long bonds (TLT) and thank me later this year. In this deflationary environment, bonds remain the ultimate diversifier.

As far as active management, I see tremendous opportunities for stock pickers on the long and short side in these markets which is why I'm a bit surprised when I hear hedge funds say there are no opportunities. There are plenty of opportunities but you need to find them on both the long and short side.

Below, a list of US exchange-traded funds (ETFs) I track closely every day to give me a good overview of the various market sectors (click on images):


This is by no means an exhaustive list but it gives me a very good breakdown of which sectors are moving every day, allowing me to dig deeper into the over 2000 stocks in various sectors and industries I track.

Again, right now my attention is completely on biotech (XBI) where I see tons of great opportunities mostly in smaller names I track closely (click on images):


You can add Nektar Therapeutics (NKTR) to this list, another biotech I track which surged 43% on Monday on promising phase 3 results from its opiod drug.

But let me repeat, investing in biotech isn't for the faint of heart and unless you can stomach gut-wrenching volatility, forget about investing in individual names, stick to the ETFs (IBB, XBI) or ignore this sector altogether.

Some of the names I track above are from my research looking at top funds' activity every quarter but trust me, just because they're top funds, doesn't mean they don't get hammered on their picks too.

Anyway, I know what Jack Bogle would tell me, don't bother trading biotech or any hot sector, invest in a balanced portfolio of ETFs, get instant diversification on the cheap and remember to rebalance your portfolio once a year or as needed. Keep it simple stupid!

Below, CNN's Michael Smerconish's full interview with Vanguard Group founder Jack Bogle, the most important figure in investing most people don't know about. Listen carefully to Bogle's words of wisdom, not just on investing but on politics, inequality and how to live a long and fruitful life.

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