4
May
2017

Dumb money

A couple of my friends asked for my thoughts on Exchange Traded Funds (ETFs). For instance, one said:

“I went into a bank, and they tried to sell me this funny derivative. It’s a bank, so I know what they are trying to sell me is good for them, not for me. How do ETFs work?”

Given the number of mis-selling scandals this scepticism towards another banking Three Letter Abbreviations (remember CDOs, CDSs and even PPI) is understandable. Although I avoid ETFs myself, they are probably less flawed than an active fund with a 5% initial fee and 1.5% charge every year, that the adviser would have suggested 10 years ago.

Definition

A traditional index tracker mirrors the performance of an underlying index such as the FTSE All Share or the S&P500.  Buying the whole basket of companies in the index is like buying the whole forest, rather than trying to select individual trees.  The big slow growing trees that are already established, and the smaller fast growing ones that might struggle for sunlight, and perhaps only succeed when a big tree falls.  The price of the index tracker is quoted once a day, calculated on the value of the underlying assets, so you know what you are buying.  It’s a low cost way of investing.

Like the index tracker, an ETF is supposed to mirror the performance of underlying asset: for instance the FTSE All Share Index or the S&P500, or even bonds or commodities like oil or gold.  Since both the ETF and the underlying basket of assets trade throughout the day, this creates brief arbitrage opportunities for financial institutions.  It is supposed to be a low cost way of investing.

 

 

 

 

 

 

 

 

It is still worth asking the question:

IF these new fangled derivatives have lower management fees, then why is the financial industry so keen to sell them?

I think the answer lies in an article I came across called Inefficiencies in the Pricing of Exchange-Traded Funds by Antti Petajisto.*
I will skip straight to the punchline. The article concludes:

“Given that US ETF assets were about $2 trillion and growing in 2014, any nontrivial mispricing in ETFs has the potential to represent a considerable wealth transfer from the less sophisticated individual investors to more sophisticated institutional investors.”

That is, although the fees are lower, how the ETF is priced is subject to “inefficiencies”. The professional institutions “smart money” exploit inefficiencies at the expense of retail investors “dumb money.” As ETFs trade on the exchanges (hence “Exchange Traded Funds”) the price can deviate from the underlying value of what you are buying. This creates an opportunity for sophisticated investors to “correct” this inefficiency, making money for themselves.

Largest ETF sponsors Total Assets $bn Institutional Ownership % Annualised Turnover %
Blackrock 809 62 606
Vanguard 469 43 193
State Street 409 63  2,222

Source: Morningstar, NASDAQ reproduced from an article by John C Bogle, Former Chief Exec of Vanguard

Vanguard, which focuses on individual investors has a much lower turnover rate than the other two large ETF providers (Blackrock and State Street), whose clients are predominately institutions. It’s not clear to me why these institutions trade so much, but we can safely guess that the trading is profitable otherwise there would be no reason for the constant buying and selling. The Petajisto article estimates the gains to institutions as roughly $38bn a year v $6bn a year in management fees for all US-listed ETFs.
It’s a bit like the airport foreign exchange desk, which offers you “commission free currency” but with the currency inefficiently priced.

So what do I do?

Other than accepting that the financial services profession is full of very clever people who will always get the better of you, there are three choices.

  • The article recommends that retail investors “trade only when markets have been flat for the last few days, because then even stale NAVs have had a chance to catch up with the latest market prices of the underlying portfolio.”
  • Buy a traditional index fund, which the financial services industry seems less keen to promote (but make sure the Total Expense Ratio is less than 1/3 of 1% ie 30bp).  UPDATE Morgan Stanley has just refused to sell Vanguard index funds to their clients. So Vanguard must be doing something right!
  • Exploit the size of the large funds against themselves. 

My friend who asked me can do either of the first two.  It doesn’t take much time, it’s a straightforward solution.**

Small money

I prefer the third option. When it comes to smaller companies the individual investor actually has an advantage. Large active fund managers are trying to have a view on HSBC and Shell, but they are uninterested in companies of £50m market capitalisation that might increase 4x in value, because such a company would still be a small part of their overall performance. This is a minority sport, in the UK only 12% of equities are owned by individuals – the rest is pension funds, fund managers, wealth managers etc.

This strategy recognises that although large fund managers (both passive and active) enjoy economies of scale in marketing, distribution and brand recognition, it is actually harder for a large fund to outperform someone with less money.  For instance, Microsoft might be a technology company, but because it is so big it is harder for the company to grow, MS revenues actually fell by $8bn in 2016.  An intelligent investor friend of mine, who successfully manages £1bn of active money thinks that the oil company, Exxon, has poor fundamentals and the share price is only doing well because of the inflow of passive money into ETFs and index trackers. With a little bit of work it’s possible to take the other side of this and buy younger, faster growing, more profitable, more exciting companies that are off the radar screen for large funds.

I mentioned that I had a couple of friends who asked about ETFs.  And this is what my second friend does too, though it’s not for everyone.  But we have similar interests (she once moved to Tblisi because she was bored, and has traveled around Iran…she probably thinks Bayes Theorem is pretty cool too).  We enjoy the creative and qualitative aspects of this approach.

Strange attractors and power laws

Expected returns follow a power law.  The bulk of the rewards lie in the far upper tail of the distribution – that is most smaller companies don’t do well, but a few do very well.   And it’s almost impossible to know beforehand.  So my professional fund manager friend likes to buy companies where hard work, intelligence, asking management the right questions and building a model gives you an edge.  Like a poker player, he looks for opportunities where the probabilities are in his favour. He won’t buy a company like Burford, because the results are impossible to forecast.  Being intelligent is no help.  He has no edge.  But most professional fund managers are playing the same game, using the same process to identify mispriced companies, which makes his job harder.

Instead, I like “unknowns” where the risks are asymetrical.  What Art De Vany calls “ambiguous probability distributions” and Mervyn King calls “radical uncertainty”.  Until I read De Vany’s book***, I never understood why Hollywood film studios spend so much money on special effects…A film with a bad storyline never becomes a great film because of the CGI. Bizarrely a film with well known faces and expensive budget is seen as more certain.  Ambiguous probabilities are psychologically harder for most people to deal with.  Hence a film with an unknown producer and without a major star is less likely to get funded.  But the percentage returns on investment from a successful low budget film with a good story (and soundtrack) is orders of magnitude higher than a big budget film.  Reservoir Dogs cost $1.2m and returned $22m.  Grease cost $6m to make, and returned $184m.  This one, Berlin Syndrome looks interesting.  It reminds me of that Oscar Wilde quote 

“Everything in the world is about sex except sex. Sex is about power.”

The same goes for anything that starts small, but has the potential to grow.  An acorn into an oak tree.  Hidden promise.  In technical language the distribution of returns is not log normal, it is stable Paretian.  Pareto was the economist who showed that wealth was not evenly distributed, but followed a “power law”.  A “strange attractor” means small differences at the start result in huge deviation in outcomes, Bill Gates versus the chap who went hot air ballooning when IBM came calling.  But rather than merely financial returns, there is something very emotionally satisfying about being involved in something successful from near the beginning and cultivating it as it blossoms.  Aside from the financial returns, I would love to have spotted baggers like ASOS, Rightmove or Trifast when they too small for people to care about.  You don’t get this emotional satisfaction from owning an index tracker or an ETF.

Owning asymetric returns

There are fund managers that specialise in investing in smaller companies.  But maybe I can do better than buying a smaller companies fund, by combining the two insights.  If I accept that if

i) fund managers are all trying to do the same, rather boring thing and they have a rather uncompetitive business model

ii) smaller stocks are where the greatest opportunities and fun is to be found.

Then along with other small companies that I own, I can buy equity in small fund management companies (whose funds tend to invest in small companies).  Instead of buying the funds that the fund managers want me to buy, which charge management fees, I just buy the equity of smaller fund management companies themselves. Then my interests really are aligned with the fund manager’s self interest.  Success is highly uncertain – the returns can’t be predicted. If the fund manager does badly and sees outflows what looks like a business with growing revenue and fixed costs (sharply rising profits) becomes a business with fixed costs and falling revenue (sharply falling profits) – yuck, very unattractive. The inflows or outflows are impossible to know, because often flows are driven by performance.     Fund managers are no better than anyone else at predicting their own performance (every fund manager thinks he will outperform the index, but most don’t).

However returns are likely to be asymetric (more upside than downside).   I can lose money, but I think that the upside might be a multiple of that. So rather than ETFs, I want to recognise that there are things that I don’t know (and can’t know) and the dispersion of returns is highly uneven.  To me, the way to profit from being “dumb money” is to buy equity in smaller fund managers, such as Miton for example (which I like but don’t own) or Impax Asset Management (which I do own).

* Inefficiencies in the Pricing of Exchange-Traded Funds by Antti Petajisto.
published in Financial Analyst Journal Volume 73 Number 1
Q1 2017

**NB – This is not advice.  If you want advice, pay for it!  The person you are paying will probably recommend buying an ETF, and so just remember to ask your financial adviser to explain how the pricing of ETFs works and why they turnover so much. 

***Hollywood Economics – How Extreme Uncertainty Shapes the Film Industry Arthur De Vany

3 Responses

  1. Great article again Bruce. I learned quite a few things from it. I like that you offer a clear point of view at the end. The market is a great teacher and you would miss out on this if you were to lump for ETFs wholesale. For me, ETFs probably do have a role to play, albeit a small one. Hopefully see you in London soon!

  2. Hi,

    one quick remark:

    Asset Mangement companies in general are “people’s businesses”. Especially in the small cap area, you cannot easily exchange managers if they are successful. If a successful manager leaves, he will take a large of assets with him. So you need to offer the “stars” more and more money the more succesfful they become, which is not unsimilar to football clubs
    If the most successful guy retires, you will also have a problem. This means that the shareholder of such a company is often at a significant disadvantage if the incentives are not aligned.

    In my experience, the most asymmetric return potential is retained by the persons working for asste mangers, not by the shareholders and alignemnet of interest is key. I have rarely found public listed asset managers where the alignement was good.

    mmi

    1. Bruce Packard

      Interesting. Yes, I can see that, because when George Godber (who I used work with at Credit Suisse) and Georgina Hamilton left Miton…the share price crashed 30%. And also the outflows when Woodford left Invesco. But I’d say the Impax business model is less about “star managers”. I hope anyway!

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