Category Archives: Financial

Corporate profit margins and income inequality

Really interesting paper from the Jerome Levy Forecasting Center.

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Is Passive crowding out Active?

FTSE Russell recently reported that market share of passive ETFs and mutual funds has grown from 12% in January 1998 to 46% at the end of December 2016.  They carefully define “passive” as funds that are intended to replicate market capitalization weighted indexes by holding the underlying assets.  Specifically excluded from this definition are other than cap weighted indexes and funds that hold options instead of the underlying.  Goldman Sachs agrees with this trend if not the exact number, reporting a change from 17% passive to 38% between 2005 and 2016.
This trend has not gone unnoticed by the active management world.  Analysts at Bernstein warn that the rise of passive investing may be worse than Marxism.  Similarly, analysts at CLSA call it “investor socialism.”  There is fear that the blind investment into all companies on a cap weighted basis will overwhelm the impact of active managers, who invest based on their research and due diligence efforts.  Additionally, the momentum effect of passive investors might be expected to result in the largest and most often index-listed companies growing to even larger market capitalizations with higher valuations, and being added to even more indexes, regardless of their economic value.  However, available data has not borne this out.
Jim Rowley from Vanguard recently posted this chart on his blog (https://vanguardadvisorsblog.com/2017/08/08/no-more-no-less-challenging-for-active/).  It shows that the percentage of stocks with significant under and over performance has not changed.  Interestingly, a chart using this same data but starting in 1998 was used to show that dispersion has gone down in a different blog post:

No historical relationship between index fund asset percentage and dispersion

Source: Vanguard calculations using data provided by FactSet and Morningstar, Inc. Index fund asset percentage is the percentage of assets in U.S.-domiciled equity funds invested in index funds. Sector funds are included.

Note: Dispersion is defined as the percentage of stocks in the Russell 3000 Index that have either outperformed or underperformed the index by at least 10 percentage points.

Data from Zacks.com shows that the equities comprising the S&P 500 individually have betas ranging from -0.02 to 2.79.  Recognizing that this is a somewhat circular reference, only one stock has a negative beta, meaning that when the market moves up, on average they are ALL moving up.  This data implies that it may be difficult to implement a long-short strategy, because the equities that underperform in a rising market are still rising, even those that underperform the most.  Beta is defined here as a 5 year calculation based on monthly returns.  This is important, because it means that the betas are based entirely on bull market data.  So they are all moving up together, but not equally.  Active opportunities exist.

Another measure of active opportunity within the stock market is the CBOE implied correlation index.  If passive investing really overwhelms active, you would expect to see correlations rise.  This effect has not been seen in the data.  See detailed explanation from Henry Ma, https://www.etftrends.com/is-there-a-passive-investing-bubble/.

Another way to look at how passive holdings might impact market function or efficiency is to compare price volatility of individual stocks in comparison to the proportion of their shares that are held in passive funds.  If passive funds are holding and not trading shares, liquidity may suffer causing spreads to increase.  Savita Subramanian at BAML has found that as the passively held proportion increases, prices become stickier; equity price adjustments based on earnings surprises are not as quickly reflected in price.  In contrast, Pravit Chintawongvanich of Macro Risk Advisors looked at realized volatility versus percent passive ownership and did not find any effect.

Arbitrage price theory posits that if an arbitrage is available, market participants will make that trade until prices reach an equilibrium where the arbitrage is no longer available.  This suggests that if the market is becoming less efficient, active traders should have an advantage and active funds should show better results.  It is only one data point, but the most recent SPIVA report (https://us.spindices.com/search/?ContentType=SPIVA) shows that active fund performance has been improving over the first half of this year.

Although active managers continue to suffer outflows to passive funds, there is scant evidence to this point that passive investing has distorted the market to the point that active investors cannot impact prices.  Active investing is necessary and, in fact, makes passive investing possible by providing price discovery for passive equity buyers.

In a separate but related topic, The New Yorker reported last year on impacts passive investing may have on the economy, (https://www.newyorker.com/business/currency/is-passive-investment-actively-hurting-the-economy).

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Fundamental Indexing

Consider the purpose of a market index.  We use an index to define the value of the market, overall.  When we use a market index as a benchmark for any specific holding or portfolio, we need to be able to rely on that index as a reasonable measurement for what “the market” is worth at any given moment, and over time.  If you are an efficient market hypothesis believer, market capitalization weighting is the only accurate way to measure the economic value of any specified market.

But what if you think that at least some of the time, prices for individual companies, sectors, and even the whole market can diverge from their true economic value?  This premise is the basis of factor investing, “smart beta,” and behavioral investing.  Several “fundamental” weighting schemes have been developed to try to measure economic value in ways other than equity price.

Dividend discount model is a simple and common method of determining the economic value of a stock.  Free cash flow models based on earnings are also widely recognized.  WisdomTree has offered both dividends and earnings weighted funds for over 10 years.  Jeff Weniger offers a thorough explanation of the advantages of earnings weighting at https://www.wisdomtree.com/blog/2017-05-15/the-wisdomtree-earnings-500-trexing-money-managements-accident-of-history and Jeremy Schwartz published a white paper in 2016 detailing dividend weighting,  https://www.wisdomtree.com/-/media/us-media-files/documents/resource-library/whitepaper/the-dividends-of-a-dividend-approach.pdf.  Pacer US Cash Cows 100 Index selects and weights the largest 100 companies by free cash flow.  The associated ETF, COWZ, just opened in December 2016.  They describe their approach here: https://youtu.be/kUyMqNq5IMo.  Please note that this is a new index as well, so it really doesn’t have a track record other than backtesting.

Oppenheimer weights by top line revenue, as explained by David Mazza, https://www.oppenheimerfunds.com/advisors/article/revenue-uncovers-value-in-a-rich-stock-market. The tech bubble is used as an example here.  You can see how at the height of the bubble, a minority of the stocks with increasing prices came to dominate the cap weighted index, but not so much the revenue weighted index.

Oppenheimer Revenue Weighting – graph from page 16 of Oppenheimer presentation – used with permission.

Rob Arnott (arguably the originator of fundamental weighting) and Research Affiliates (RAFI) have developed 3 unique indexes, which weight companies with varying combinations and definitions of sales, cash flow, dividends, and book value.   The FTSE RAFI US 1000 Index consists of the 1000 largest companies as calculated by their economic value, using a formula including total cash dividends, free cash flow, total sales, and book equity value.  Invesco, who sponsors the ETF for this index (PRF), shows the converse of the Oppenheimer example:  during the last crisis, the financial sector became under valued, and thus under weighted in the cap weighted index.

Invesco chart – used with permission.

Critics of the fundamental approach to indexing call it value investing by another name.  This is true by definition.  However, the difference between a value index and a fundamental index is that the fundamental index is not using the equity price in any form to determine inclusion or weight in the index.  A value index will always include some form of the price in its inclusion and/or weighting calculations, usually in a ratio (P/E, P/S, etc.).  The amount of value tilt changes over time for a fundamental index, while it is defined for a value index.  Issuers of fundamental indexes consider this a feature, not a bug.  The goal of the fundamental index is to represent the market constituents weighted by their economic value or economic impact, not to determine which equities or sectors are “incorrectly” priced.

What about performance?

As of 6/30/17 3 yr 5 yr 10 yr
YTD 1 yr 3 yr 5 yr 10 yr sd beta sd beta sd beta
S&P 500 TR Index 9.34 17.9 9.61 14.63 7.18 10.35 9.56 15.21
FTSE RAFI US 1000 Index 4.69 16.92 7.89 14.82 7.68 10.25 0.96 9.73 0.99 16.02 1.04
WisdomTree LargeCap Dividend Index 6.7 14.23 9.08 13.19 6.72 9.87 0.93 9.12 0.92 14.63 0.93
OFI Revenue Weighted Large Cap TR 7.41 16.49 8.7 15.55 7.29 10.38 0.98 9.9 1.01 16.51 1.07
WisdomTree US Earnings 500 Index 9.39 22.29 9.46 14.65 7.35 10.81 1.03 9.91 1.02 15.03 0.98
Pacer US 100 Cash Cows Index 6.74 23.15 9.02 16.98 10.32 13.46 1.2 12.41 1.2 19.83 1.21
Russell RAFI US Large Company Index 4.8 14.2 7.75 14.3 7.91 10.25 0.96 9.73 0.99 16.02 1.04
*Data from ETF providers and Morningstar

Please note that the outlier in this group, Pacer, reflects backtesting data prior to 2017.  The three year betas less then one suggest that the fundamental indexes are not performing as well as the S&P 500 over this portion of a bull market, and they are not.  A full market cycle would be the best way to evaluate performance.  The 10 year betas less than one might be what is expected – a dampening effect from removing the impact of excess pricing at market highs, and oversold equities at market lows. Another way to look at it would be that the market tends to overshoot at both extremes – the real economy is not moving as much.  But of the 6 indexes, only 2 reflect this theory.

What explains this?  The fundamental indexes are rebalanced quarterly or annually, while a cap weighted index self-rebalances on a continuous basis, other than adjustments for changes in listings and float. Rebalancing also adds trading costs as well as possible tax liabilities.  RAFI methodologies use 5 year averages of data, so they will be slower to respond to changes in issuer value than the cap weighted index.  The Oppenheimer and WisdomTree indexes are also capped by issuer and sector.  Similar to smart beta, it’s just more complicated to implement these strategies than cap weighted.

The ETFs based on fundamental indexes generally charge around .25% – .50%, while the cap weighted index ETF can be bought for .03%.  The 10 year returns net of fees are very similar to the cap weighted index.  Other cost considerations are size and trading cost of the ETFs, as well as tax implications. Obviously dividend weighted funds will have higher taxable income than cap weighted.

In summary, the theory of the fundamental index is quite compelling, but the current indexes somewhat less so. It seems likely that this reflects the difficulty in implementation rather than flaw in theory.

Disclosure:  I do not currently hold or plan to add any fundamental weight products for myself or clients.  Do have positions in cap weighted funds and ETFs.

 

 

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Fiduciary Rule blowback from customers

Rick Kahler recently reported that a J.D. Power survey showed that current clients of brokers are likely to leave when switched to fee-only accounts.  He envisioned a conversation like this:

Broker: “Because of the new DOL regulations I can no longer sell you a high fee and commission variable annuity to be owned by your IRA. To comply with the ruling, my company has eliminated the 7% upfront commission on this annuity; we will now charge you a 1% annual fee. They also reduced the annual management expenses from 3% to 1%. Plus, now any advice I give you or product I recommend must be in your best interests.”

Customer: “So you are eliminating the upfront 7% commission and replacing that with a 1% annual fee, which means 7% more of my money immediately goes to work for me in the investment, right?”

Broker: “That’s right.”

 

Customer:  “And instead of the upfront commission you are charging a new 1% annual fee, but reducing the annual management costs of the investments from 3% to 1%. So I’ll still make an additional 1% every year I own this, in addition to saving 7% up front, right?”

Broker: “That’s right.”

Customer: “And further, you’re now going to look out for my best interests rather than the best interests of your company.”

Broker: “Yep.”

Customer: “This is ridiculous. I’m outta here!”

Broker: “Where are you going?”

Customer: “To find a firm that will continue to sell me high commission, high fee products for my IRA and that will work against my best interests!”

Broker: “You probably won’t find any. Every financial company selling investment products to IRAs has to comply.”

Customer: “I’ll find someone, somewhere. Goodbye!”

I envision a conversation more like this:

Broker: “Because of the new DOL regulations I can no longer sell you a high fee and commission variable annuity to be owned by your IRA. To comply with the ruling, my company has eliminated the 7% upfront commission on this annuity; we will now charge you a 1% annual fee. They also reduced the annual management expenses from 3% to 1%. Plus, now any advice I give you or product I recommend must be in your best interests.”

Customer:  “So you’re telling me that for all these years, you have been taking a 7% cut right off the top, and charging me 3 times the expenses for no reason other than to take more of my  money and put it in your pocket??”

Broker: “ummmm…….”

Customer: “And further, you’ve never been out for my best interests, but rather the best interests of your company?”

Broker: “ummmm…….”

Customer: “This is ridiculous. I’m outta here!”

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More about ETF liquidity and the underlying assets’ liquidity

Sorry for the ridiculous title.  Not clickbait.

Noah, from Noahpinion, posted at Bloomberg, which was reposted at wealthmanagement.com:

It’s Smart to Worry About the Risks ETFs Pose

Remember how mortgage-backed securities turned out?
Now *that’s* a clickbait title.
The article is actually a lot more interesting than the title implies.

My own biggest worry about ETFs revolves around liquidity.

There is no single unified definition of liquidity. In general it means the ease with which you can trade an asset, but that depends on conditions in the market — mortgage-backed securities were plenty liquid before the crisis struck, but became incredibly illiquid once people started doubting the quality of their ingredients.

ETFs look very liquid, because as the name implies, you can trade them on exchanges. Take a thousand hard-to-trade bonds and pile them into an ETF, and you suddenly have one bond fund that the lowliest retail investor can buy and sell at will.

But what happens in a crisis? Suppose some bonds turn out to be a lot lower-quality than most investors believed. Without ETFs, those bonds would plunge in price, but other bonds would be fine. But now imagine that both the bad bonds and the good bonds are all bundled into ETFs. Now, when the bad bonds are discovered to be bad, investors who ignored the composition of their funds will suddenly wake up to the fact that they might contain toxic assets. Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don’t.

With assets like stocks, this isn’t so much of a danger — when stocks go bust, everyone can see which ones are bad. But when the ingredients in an ETF are complex, highly heterogeneous assets, as is the case with many bonds and derivatives, one ETF might be fine while another is worthless, and yet investors may ignore the differences until it’s too late.

Another possibility, pointed out to me by a friend in asset management, is that some of the individual securities in an ETF might start to have their own liquidity problems. If banks or other big broker-dealers suddenly become unwilling to facilitate the trading of certain kinds of bonds, ETFs that include large amounts of those particular bonds might suddenly plunge in price. Investors now buying up ETF shares might not realize that danger, thus leading to general overpricing.

So the more bespoke and exotic markets ETFs expand into, the greater the worry that they could be involved in a 2008-style liquidity crunch. That could pose risks for key financial institutions that hold ETFs, and it could also spell danger for individual investors’ retirement savings.

A few people are already worrying about this possibility, which is good. The more we worry about financial innovations in advance, the less chance we’ll need a crisis to teach us the limits of those innovations.

This is sort of the flip side of my earlier post regarding bond mutual funds vs. ETFs.  My assumption is that traders will quickly price in the illiquidity of the underlying assets.  His assumption is that they will not, or may not.  I think if you are investing in funds of illiquid assets, though, you are still better off in an ETF than a mutual fund if you are a buy and hold investor.  This article gives you even more reason to hold a mutual fund if you plan to sell into a downturn.

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ESG vs. Returns

Great post from Asness regarding ESG.  The bottom line is, if you are trying to encourage good behavior, you should expect that your goals do not come free of charge – there should be a cost to total returns.

Pursuing virtue should hurt expected returns. Some have discussed this fact. But, it’s still not widely understood or broadly accepted. This seems to arise from investment managers selling virtue as a free lunch, and from investors who very much want to believe in that story. In particular, and my focus here, accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it’s precisely the point (though its necessity may indeed be unfortunate). As an ESG investor this lower expected return is exactly what you want to happen and really the only way you can effect the change you seek

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Fed Balance Sheet unwind

Michael Arone at SPDR Blog has added a bunch of global data to the info I posted previously regarding the Fed’s balance sheet.  He includes some information about current and future levels of required reinvestments (maturity dates) but really doesn’t touch on how equity markets might be impacted.

There are a bunch of cool charts (and one really, really dumb one, click on the link and you figure out which one).

Here’s a couple:

growth_in_global_central_bank_assets_1160x760

us_treasuries_and_china_fx_reserves_1160x687

 

Importantly, he noted that the Chinese sale of treasuries was related to their desire to control the level of the yuan, not some general panic over US Treasuries, as that action is often portrayed.

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