Innovate, Repent, Repeat
Every few years Wall Street trumpets the arrival of a new financial product or concept -- one that will bolster returns while providing superior risk management. Claims of financial innovation have been a recurring phenomenon of Wall Street's highly cyclical landscape. Often during these periods, proclamations of a new paradigm flourish, with the new orthodoxy quickly replacing the old. But, even a cursory study of financial history reveals that many of these claims turn out to be disappointing at best ... and, outright fraudulent at their worst.
True to form, the well-known episode of late arrived under the banner of "structured finance." Securitization was a new form of financial alchemy that promised to disperse risk while improving returns. Originally, the securitization process simply involved pooling and repackaging certain cash-flow producing financial assets into securities (known as asset-backed securities).
It was a slippery slope from there. Re-securitization of securitized assets became common, further separating investors from the loan originators. Dangerously, the loan originators did not bear any long-term risks ... loan assets were quickly packaged and sold off. Rather predictably, lending volumes surged as originators focused less on credit quality and became more motivated by fee revenue. Of course, poor lending standards eventually led to massive losses for investors in a variety of asset-backed securities. Ultimately, like many other forms of financial innovation, securitization was not immune from, and eventually gave way to greed and a total denial of risk.
What about developments in the exchange-traded fund industry? Are recent innovations here a positive contribution to the investment landscape? There have been skeptics. Readers of ETFocus will be aware that we are stalwart supporters of the ETF vehicle in its pure form. We have long argued that the arrival of ETFs is a positive step forward in the wealth management industry ... re-shaping investor economics and global portfolio construction. But how can investors be sure that these vehicles will not be subject to outrageous excesses as so many financial innovations of the past? After all, on Wall Street, trends come and go as regularly as teenage crushes. Today's hot product or concept could be tomorrow's discredited, intellectually bankrupt idea.
Innovation or Flawed Structure? Debt as a Differentiator. Not all financial innovation has been relegated to the dustbin of history. A good litmus test is whether credit plays a role. Specifically, if financial innovation is accompanied by new debt-generation, this is often an important differentiator between good and bad forms of financial innovation. Crucially, periods of credit excess are nearly always catalysts of financial instability. For example, securitization and related structured vehicles (e.g. CDOs, CMBSs or CLOs) allowed debt to expand rapidly, creating a complex and fragile set of opaque risks. Ultimately, these developments contributed to the intensification of an unsustainable housing bubble and the resulting fallout. (For a further analysis of debt and asset bubbles, see ETFocus "Bubble Trouble?", August/September 2008).
Tools, Not Complete Portfolio Solutions. Applying the above credit extension test to ETFs, we know that the traditional passively-indexed variety do not contribute to the expansion of debt. In fact, conventional ETFs simply wrapped a variety of targeted global assets classes in a more transparent, lower cost, tax efficient investment vehicle. That's hardly a negative development. These positive aspects of ETFs are merely the result of advanced technology, competitive pressures and the evolution of financial markets (not the result of or cause of new forms of leverage). But while the entrance of traditional ETFs has been a boon to investors, there are now growing risks in the ETF space. For one, the line is starting to blur between the first-evolution ETFs and newer products coming to market. What was first a form of true innovation has now morphed into a more complex set of products ... in some cases, bearing little resemblance to the initial ETF form. Let's define the broad categories of the new ETF environment and highlight some of the key risks:
1. Active Wrappers: Actively-managed and hedge-fund replication ETFs in particular introduce new and complex risks, and are a significant departure from the original ETF design. Fees and portfolio turnover will surely be much higher. While it is always beneficial to place any investment strategy into the more efficient ETF wrapper, the challenge of outperforming applicable benchmark indexes will remain. This is the key argument for using low-cost, passively-managed ETFs for exposure to certain asset classes. Certainly, the advent of actively-managed ETFs will further ignite competition between ETFs and mutual funds (the latter being predominantly actively-managed). However, even here it will be hard for the traditional mutual fund structure to compete with a more transparent, flexible, liquid and tax-efficient vehicle. We will be monitoring and reporting on these developments in future editions of ETFocus.
2. Trading Tools: Leverage and inverse ETFs have now become alarmingly popular trading instruments. Direxion's leveraged ETFs are routinely listed as the US's most active stocks by volume. But these are short-term vehicles used for speculation or hedging ... not suited for the long-term oriented investor. These funds only attempt to deliver the leveraged daily performance of an index. Crucially, leverage exacerbates volatility. Following the mathematics of time-linked returns, this means their performance over periods greater than a day won't necessarily match the leveraged return of the applicable index (i.e. there is a large difference between tripling the daily return and tripling the annual return). As such, over longer horizons, return profiles can vary dramatically from underlying exposures. Many investors, who were not aware of this characteristic, have already been burned here.
Figure 1 shows a worrisome trend -- ETF trading activity is surging (both in nominal terms and measured as a percentage of ETF assets). Global average trading volumes (measured over 20- day periods) for the first quarter came in at USD 88.1 billion on a total asset base of just USD 633.8 billion. Investors should exercise caution here. Studies have consistently shown that over-activity in investor portfolios virtually guarantees sub par performance. Dalbar Inc., a financial services market research firm, releases its annual Quantitative Analysis of Investor Behaviour that reaches the same conclusion every year: the average investor continuously earns only a fraction of market returns. According to Dalbar's 2008 report, from 1988 to 2008 the average mutual fund investor in a balanced fund (a benchmark based on Barclays' aggregate bond index and the S&P 500 composite index) achieved a 1.67% annualized return while the passive benchmark achieved a return of 7.89% and inflation averaged 2.89%.
The study determined -- as it does every year -- that the primary reason for the average investor's low return was that investors tended to buy "high" and sell "low." Investors were inclined to flee markets when they had already fallen, buying them only when optimism had returned. To illustrate this, Dalbar tracks mutual fund flows and identifies a long running correlation: inflows surge after market rises, while outflows increase immediately after market declines. Reactive emotions again drive decision-making, suffocating analytical faculties and setting investors up for failure.
3. Asset Management Vehicles: We have long argued that the traditional variety of ETFs -- passively-managed, non-leveraged core building blocks for globally diversified portfolios -- represent a truly sustainable and beneficial paradigm shift in the wealth management industry. Even here, however, there are risks (in addition to the behavioural risks cited above). Perhaps the most important point to emphasize is that the asset allocation decision is unavoidable regardless of the investment vehicle to construct portfolios.
Our stance continues to be that active and passive approaches are not mutually exclusive. A dual strategy of using passive ETFs combined with a disciplined risk management framework that actively focuses on asset mix can be a successful one. Why active asset mix? In short, risk management. Financial history has repeatedly shown that all types of asset classes can become grossly mis-priced, whether it is technology stocks in the late 1990s or South Sea stocks in early 18th century England. Realigning portfolio allocations at these extremes should be a critical part of any investment strategy. As money manager Jeremy Grantham has noted: "Asset allocation is simply much easier than adding alpha to a fund, since there is more to sink your teeth into. Counter-intuitively, asset classes are more inefficiently priced than stocks ... consequently, there is great advantage to be had in getting out of the way of the freight train, rather than attempting to prove your discipline by facing it down."
Conclusions. Unwary investors have been frequent casualties of Wall Street's financial innovations, either those that have or have been taken to excess. Whether it's the creation of "structured" mortgage products or the declaration of a new era of "permanent prosperity," it has proven a familiar road that leads to disaster, according to financial history. In an environment of heightened transparency, there are some ETFs that are solidifying their place as a source of authentic innovation. However, an ETF in name is not always deserving of the positive reputation that was earned on its first evolution. Investors, beware!