From Sesame to Elm Street

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ETF markets continue to surge in popularity. With low fees and basic packaging of the ETF product even Big Bird can understand what The Count is going on about. No wonder investors are snapping up these products faster than the Cookie Monster. However there is something chilling about the ETF market. In the lead up to and eventual crash of Lehmans et al CDOs, CDSs and other synthetic products were seen as the root of all evil. They were so complex that even Fields Medal winners in mathematics couldn’t make head nor tail of them. The ETF became the opposite – being too simplistic – and with that the product has brought huge complacency. To that end Sesame Street could well switch to Elm Street.

Today assets invested in ETF/Ps comprise over $3 trillion globally. Put simply the new funds flowing into ETFs vs. traditional mutual funds is at a 100:1 ratio and in terms of AUM is on par with total hedge fund assets which have been in existence for 3 times as long.

However ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. A full report can be seen here.

With the continuation of asset bubbles in a TINA (there is no alternative) world, ETFs in my view will lead to massive disappointments down the line. Their downfall could well invite the revival of the research driven fund manager model again as robots show they’re not as infallible as first thought in managing the volatility. Don’t forget humans designed the algorithms.

There is also the added risk of whether some ETFs actually hold the physical of the indices or commodities they mimic. A gold ETF is a wonderfully good way to store wealth without resorting to one’s own bank vault but how many ETF owners have inspected the subterranean cage that supposedly holds the physical the ETF is backed by? Has it been lent out? Does it own a fraction of stated holdings? It could be any other commodity too. Of course the ETF providers bang on about the safety of the products but how many times have we gasped when fraud reared it’s ugly head right in front of us. Bernie Maddoff ring any bells?

Given the implied volatility on the downside we need to bear in mind the actions of central banks. The Bank of Japan (BoJ) is the proud owner of 60% of the ¥20 trillion+ domestic ETF market. While the BoJ says it isn’t finished expanding its world’s largest central bank balance sheet (now 100% of GDP), the US Fed is looking to reduce its balance sheet by over 40% in order to normalize. While one can applaud some level of common sense pervading sadly the consequences of defusing the timer on the bomb they created at a period when the US economy is showing signs of recession will only be an overhang on asset markets. Should the US market be put through the grinder, global markets will follow.

It is one thing for the Fed to be prudent. It is another for it to be trying to cover its tracks through higher interest rates in a market that looks optically pretty but hides serious life threatening illnesses. The Fed isn’t ahead of the curve at all. It is so far behind the 8-ball that its actions are more likely to accelerate rather than alleviate a crisis. Point to low unemployment or household asset appreciation as reasons to talk of a robust economy but things couldn’t be further from the truth. Wage growth is not the stuff of dreams and the faltering signs in auto, consumer and residential markets should give reason for concern.

Since GFC we have witnessed the worst global economic revival in history. The weakest growth despite record pump priming and balance sheet expansion. Money velocity is continually falling and the day Greenspan dispensed with M3 reporting one knew that things were bad and “nothing to see here” was the order of the day.

Record levels of debt (just shy of $220 trillion or 300% of GDP when adding private, corporate and government), slow growth, paltry interest rates and coordinated asset buying have not done anything other than blown more air into a bubble that should have been burst. GFC didn’t hit the reset button. Central banks just hit print to avoid the pain. We’ve doubled up on stupidity, forgot the idea of prudent and sensible growth through savings and just partied on. Ask any of your friends in finance what they “really” think and I can assure you that after a few drinks they’ll tell you they’re waiting for the exit trade. They know Armageddon is coming but just don’t know when

Whether we like it or not, the reset button will be hit. I often argue people should not worry about the return ON their money but the return OF it. Global markets can’t be bailed out again with massive cash infusion. That has been a recipe for disaster, only widening the gap between haves and have nots. Debt must be allowed to go bad, banks must be allowed to go bust and free markets must be freed from the shackles of state sponsored manipulation to set prices. It will be ugly but more of the same can kicking won’t work.

ETFs are a sign of the times. They represent the slapdash approach to life these days. Time saving apps if you will. However nothing beats hard nosed analysis to understand what awaits us. Poor old Big Bird will be the canary in the coal mine and Sesame Street will be renamed Elm Street as the Kruger’s move in to give us nightmares Janet Yellen assures us aren’t possible.

Perhaps that is the ultimate question. As you go to work each day do you honestly feel that things are peachy as the management town hall meetings would have you believe? Are your friends or colleagues all bulled up about the future? Perhaps that is easier to answer than an ETF.

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