etfs, etps, and passive management: unmitigated risks? · 2018-03-09 · etfs, etps, and passive...

Monthly Strategy Report March 2018

Joan Bonet MajóDirector, Market Strategies

ETFs, ETPs, and Passive Management: Unmitigated risks?

Monthly Strategy Report. March 2018

ETFs, ETPs, and Passive Management: Unmitigated risks?

Recent regulatory changes coupled with the constant pursuit of lower management costs has led to a sharp increase in passive management and ETPs (Exchange Traded Products) which, in the last four years, have double in investment volume. Last year alone, ETPs grew by USD 1.2 billion (+36%), 97% of which are ETFs (Exchange Traded Funds).

Graph 1: Global ETP Market.

Source: ETP Landscape, BlackRock.

These types of products, which trade on security exchanges, aim to replicate the composition of a given index in order to gain exposure to a particular index or market quickly, efficiently, and inexpensively. Twenty-five years have passed since the first ETF was launched in 1993, and over time, the degree of sophistication and complexity has advanced significantly. These days it is possible to buy ETFs that simply replicate indices, like the IBEX 35, or leveraged structures in derivatives that multiply the behaviour of the underlying index several times, or indices of commodities, bonds, volatility, and even active investment strategies or investment strategies by factors.

This situation is transforming the foundations of investment, affecting everything from the decision-making process to the composition of many indices and markets. Some investors, like famed philanthropist Carl Icahn (known for the hostile takeover of TWA in the mid-1980s, among other operations), have warned of the dangers of these types of instruments. They argue that when investors channel their bets through indices, without examining the fundamentals of each company or the components of the market in which they are investing, they help divert the share price from the fundamental value of the assets, leaving their positioning exposed to greater vulnerability vis-à-vis any unforeseen change in expectations. They also caution against the formation of “price bubbles” in certain assets, as well as a lack of liquidity in some markets totally influenced by “new trends” that often decouple the share price from the fundamental value of the asset.

In fact, in early February alarms sounded upon learning of Credit Suisse’s decision to liquidate its ETN XIV Velocity Inverse VIX Short-Term, after plummeting more than 80% and volatising nearly USD 3 billion. The publication of a US wage figure that exceeded estimates, caused the VIX volatility index on the S&P 500 (the inverse reference of this product on which the price variation multiplied three-fold) to experience the highest one-day spike of all time by triggering massive volatility purchases and precipitating the collapse of the product, in addition to sharp declines on the stock indices.


The occurrence of these events gives us a good opportunity to put the facts in perspective and argue our view that, despite strong growth in passive management and ETFs, they still only represent a limited portion of the overall market and we believe that they are not to blame for all the evils of the market.

It is important to note that one of the main reasons for the emergence of this type of product are certain regulatory changes that have taken place in recent years. While Basel III and the Volker Rule (approved in the US) aim to increase the capital requirements of financial institutions and reduce the ability of banks to maintain direct bond inventories, the US Department of Labor (DOL) rule, the RDR and MiFID II in Europe have increased the fiduciary responsibility of advisors and forced an increasing reduction in the cost of the instruments used to invest in many portfolios, thus boosting the appeal of ETFs.

Despite the strong growth reported, total assets in indexed products currently account for 10.3% of investable products overall, a figure that underscores the alarmist supposition about the prevalence of passive management.

Graph 2: Proportion of indexed products vs. total assets.

Source: Bank of International Settlements, Strategic Insight Simfund, BlackRock, Bloomberg (8/2016).

Moreover, it is interesting to note that active management strategies continue to have higher turnover ratios. Using as an example the US equity market (which has the highest ETF use rate—7.6% vs. 1.5% in Europe), at present 22 dollars are traded by active managers for every one dollar traded through indexed management.

At Banca March, where we have always been characterised as active management investors, picking and managing products based on a rigorous analysis process and our market forecasts, we believe that in some circumstances (ie: for tactical positioning, niche markets, or remarkably efficient indices), it makes sense to complement the management process by channelling investment ideas through indices. One must be especially meticulous in the selection process because not all products are the same, and although ETFs currently comprise 97% of the global ETP market, determining the counterparty risk of each product is essential to avoid issues like those that arose earlier in the month.


As the table illustrates, it is very important to analyse whether the structure is one of physical or synthetic replication in order to mitigate counterparty risk.

Surely, despite the strong growth reported, passive management will continue on the upswing before posing a formidable threat to the market.

Monthly Strategy Report March 2018

Banca March Market Strategies Team:

Joan Bonet Majó, Director, Market Strategies Team

Pedro Sastre, Director, Analysis Services

Paulo Gonçalves, Specialist Technician, Research Services

Volatility returns to equity markets


Volatility returns to equity markets

Global stock markets reacted to fears of monetary stimulus withdrawal….

February closed with a negative performance for the main global stock markets, but the most noteworthy and common element across all equity markets was the return of volatility. The concern that an upturn in inflation will result in a hasty withdrawal of monetary stimulus from the Central Banks quickly raised the interest rates required on public debt and ignited fears that a tightening of financial conditions would halt economic growth. This was one of the reasons for the rise of uncertainty, or rather, the “excuse” for a stock market correction after several months of notable appreciations.

…and, after being absent last year, volatility returned to the markets.

Volatility, which had been absent from the indices last year, reappeared on the markets. This is not surprising since 2017 was an unusual case in which the volatility of the MSCI World stood at 5.9% at the end of the year, well below the 16% average of the last decade.

Graph 1: Implicit volatility (VIX index).

Source: Bloomberg and own calculations.

The upsurge in hourly wages in the US raised inflation expectations…

The inflation data that prompted this uncertainty primarily concerned the US economy. In January, the hourly wage figure rose more than expected, registering growth of +2.9% y-o-y, the highest level since the financial crisis. If we break down the data, however, we see that there are exceptional factors affecting this figure and, in fact, it was a decrease in hours worked that increased the ratio of hourly wages rather than the excessive acceleration of wages. It would, therefore, be premature to conclude that this data indicates a shift in trend toward strong and excessive wage growth.


Graph 2: Ratio of hourly wages (United States).


…although there is no inflationary pressure in other economies.

In other economies, inflation figures remained contained in January. Such was the case in the eurozone, where CPI stood at +1.3% y-o-y with the core rate at +1%. Emerging economies, like China and Brazil, reported lower-than-expected inflation figures, with CPI at +1.5% and +2.9%, respectively.

These data, compounded by messages of monetary policy continuity, prompted concerns throughout the month that inflation would accelerate excessively in the short term.

The Fed chair and the ECB president confirmed they would maintain their respective courses.

The new Fed chair made his first semi-annual appearance before the US Congress. The meeting focused on the profile of Jerome Powell, who will now lead the Fed and who, on this occasion, advocated a continuous approach, noting that rate hikes will be gradual.

Meanwhile, in the eurozone, the president of the ECB appeared before the European Parliament, where he was confident that the improvement in activity would continue, but dampened expectations of an imminent withdrawal of monetary stimulus, stating that authorities are awaiting confirmation of a sustained rise in inflation given that, for the moment, it is far from the 2% target.

Sharp stock market declines, especially in the first half of February…

The aforementioned events impacted markets, which began February with considerable declines for most assets. Equities, however, recovered slightly. The positive corporate earnings season supported this recovery: using the S&P500 as a reference, profit growth reached +14.5%, but more importantly, sales showed remarkable dynamism, advancing +7.6%. This enabled the US stock market (S&P 500) to close February with a decline of only -3.9%, far from the -8.5% that it hit during the month. It should be noted, however, that the cumulative appreciation for the year is +1.5%.

…led to mixed cumulative results for the year: positive for US and emerging, negative for Europe.

In other regions, February’s declines were more pronounced: the aggregate of emerging stock markets fell -4.7%, but remained positive for the year overall (+3.2%). In Europe, meanwhile, the Eurostoxx50 shed -4.7% and the Ibex35 fell -5.85%, situating the cumulative declines for the year


at -1.9% and -2%, respectively.

Fears of a rebound in inflation led to fixed income losses.

Investment-grade sovereign bonds were adversely affected by the fear of an upturn in inflation, especially in the United States, with a +16 b.p. rebound in 10-year rates, to 2.86%, leading to losses of -0.75% for the aggregate US public debt index. In Europe, rates remained more stable, particularly after Draghi’s statement confirming that stimulus withdrawal would be gradual: in the case of the 10-year German bond, rates closed February at 0.66% (-4 b.p.), while the Spanish equivalent performed worse: the aggregate public debt index lost -0.15%, with the required 10-year yield climbing to 1.54%.

Likewise, the credit market suffered losses due to the increase in base rates, but, on the upside, risk premiums required from companies rose only slightly. Specifically, the global investment-grade credit index dipped -1%, while high-yield shed only -0.8%. Emerging debt also closed with declines: the one denominated in local currency lost -1.2%, while the one in foreign currency lost -2%.

The dollar was buoyed by the divergence in monetary policies.

In February, the dollar recovered much of the losses from the previous month and the greenback appreciated in the crossover against the euro to 1.22 EUR/USD (+1.7% for the dollar), bolstered by the divergence of monetary policies. The pound, meanwhile, accelerated its depreciation in light of the latest standstill in Brexit negotiations that lessen the chances of reaching a transition agreement under the conditions favoured by the British executive. In this context, the euro-pound crossover closed at levels near 0.89 EUR/GBP (-1.3% for the pound).

Oil and gold declined on increased production and the rise of real interest rates.

On the commodity market, oil prices closed with declines of -4.7% for a barrel of Brent, under downward pressure from the rapid increase in production in the United States and from concerns of slower growth in the coming months should the increase in real interest rates continue. The latter factor also explains the decline in the price of gold, which is not benefitting from its usual role as a haven asset. Despite greater uncertainty and rising inflation expectations, an ounce of gold lost -2% in February, to $1.318/ounce.


Strategy for March 2018

Normalising inflation and the risk of an accelerated shift in monetary policy invite greater caution.

The debate between rising economic growth and normalising inflation, or the risk that an upturn in inflation will abruptly alter monetary policy bias thus curbing global activity, will persist in the coming months. As such, the rebound of stock market volatility in early February will not be the last episode of its kind this year. If one thing is clear given the current economic context, it is that 2018 will not be a placid repeat of last year for shares, with appreciations and barely a single “shock.”

However, strong economic growth will continue to bolster shares.

Economic fundamentals remain positive and continue to reinforce the prospects that economic expansion will persist this year. However, the most recent leading indicators published suggest that the strongest point of acceleration of global growth is already behind us. Barometers such as the eurozone’s business and consumer confidence indicators, that in February collapsed after hitting a 10-year maximum in January, are reflections of this trend.

These figures reaffirm our assessment that the first half of the year should mark the cyclical moment of greatest economic dynamism, after which global growth will stabilise at rates that are still strong and higher than the historical average.

Inflation will continue to rise, but we think it will remain contained…


In this context, economic dynamism does not appear to represent a curtailment of medium-term risk asset performance. Nevertheless, inflation will be of particular relevance in the coming months. In our core scenario, we expect the uptrend to continue, and in Q2’18 we will see higher-priced consumer goods, but without higher energy prices inflation will ease again toward year-end, once the base effect of crude oil price comparisons recede. If these expectations are confirmed, inflationary pressure will continue upward but remain contained.

…allowing for a gradual exit strategy of the Central Banks.

We expect the Fed will continue its course, which would include three or four additional rate hikes this year, while the ECB will wait until 2019 to do the same. Naturally, the Central Banks will continue with the gradual withdrawal of their monetary policies.

The money market fund remains positive for the performance of risk assets, and for equities in particular. Despite the market’s uncertainty in February and the spike in volatility in recent weeks, there has not been a serious deterioration in financial conditions that would make us fear an abrupt halt in global activity in the short term. As such, corporate profits will continue to grow at an elevated rate and serve as a support for stock markets.

Increased profits will result in stock market gains...

According to this year’s expectations, profit growth will accelerate +15% worldwide. Moreover, in recent weeks, estimates have continued to increase, distancing themselves from stock market trends, a factor that should be corrected by a recovery in share prices.

Graph 3: Evolution of expected profits vs. the S&P500.


… we prefer sectors closely linked to the economic cycle and less affected by rising interest rates.

Among equities, we remain comfortable with sectorial distribution, favour investment in banks and financial companies, and recommend exposure to the recovery of the investment cycle, particularly in Europe, with names from the industrial sector. We also continue to see potential in the tech sector. All of the foregoing reassures us that the cyclical sectors will continue to lead stock market gains.


Graph 4: We maintain a positive outlook for cyclical sectors.


Bonds concentrate the greatest risk of losses in this economic scenario...

Despite the sharp drop in the price of investment-grade sovereign debt, we still recommend avoiding exposure to this asset class. If we use the 10-year US or German bonds as a reference, in just over a month and a half, cumulative losses surpassed -3.5%. Nevertheless, we continue to perceive a risk of additional declines in an economic context of rising inflation where the expansionary monetary policy is drawing to a close. As the graph below illustrates, the declines from maximum highs are heftier with regard to sovereign public debt than the main US stock index.

Graph 5: Declines from maximum highs in US sovereign debt.

Source: Bloomberg and own calculations (data from 28 February).

…which is why we recommend short durations and avoiding investment-grade sovereign debt.

We have warned of this risk, which has escalated in the first couple months of the year. Current sovereign bond rates with long maturities still present a high likelihood of further losses. Therefore, we continue to recommend maintaining short durations in bond portfolios.

Monthly Strategy Report. December 2017

In light of this, we expect a recovery in emerging debt.

The potential of corporate credit appears to be on the decline, and therefore, we recommend greater caution in both investment-grade and high-yield corporate bonds, where the further tightening of required spreads could be used to reduce exposure to this asset. In terms of opportunity, in our opinion, emerging debt is the most attractive among fixed-income assets, now that the growth of emerging economies is stronger.

Any further appreciation of the dollar would be used to reduce exposure.

The dollar’s potential waned. Although in the short term it is expected that the interest rate spread will boost the dollar vis-à-vis the euro, the latest decisions and actions of the US administration devalue the structural prospects of the US currency. Therefore, the positioning will be reviewed and upon confirmation that the euro-dollar crossover will again trade below 1.20 EUR/USD, that movement would be used to hedge positions.

The risk of protectionism re-emerges.

An additional risk that has emerged in recent days is protectionism. The Trump administration’s proposal to raise tariffs, arguing that these measures will protect industry, improve domestic demand, and ultimately result in higher economic growth, raised concerns. Particularly puzzling is the fact that the economies that export the most steel to the United States have historically been her allies. Specifically, steel imports come mainly from Canada (16%) and the EU (15%), with only 2% originating from China. In a world of open economies and increasingly global trade channels, the effect of greater domestic growth advocated by the US administration will likely be appeased, but will depend to a large extent on the actions of other economies.

The improvement of world trade served as one of the pillars of the recovery, and another important consequence of lower barriers and more international transactions was an increase in competition on the markets for goods and products, which helped keep inflation contained. Therefore, a sudden shift in this scenario would trigger lower growth and a rebound in inflation that would be a drag on markets.


Equity Indices IBEX35 (3 years)

Euribor Euribor 12 months (3 years)

EUR/USD (3 years)

10 years government yields

Currencies

Government Bonds

Corporate Bonds (1 year spread)

Commodities

Data: Bloomberg


Equity Indices performance (3 years)


Important Remark:

This contents of this document are merely illustrative and do not pretend, are not and cannot be considered under any circumstances as an investment recommendation towards the contracting of financial products.

This document has only been prepared to help the customer make an independent and individual decision but does not intend to replace any type of advice needed for the contracting of such products.

The terms and conditions described in this document are to be viewed as preliminary terms only, subject to discurssion and negotiation as well as to the agreement and final drafting of the terms affecting the transaction, which will appear in the contract or certificate to be issued.

Consequently, March Gestión de Fondos, S.G.I.I.C., S.A.U. and its customers are not bound by this conditions concerning the final documents to be approved. March Gestión de Fondos, S.G.I.I.C., S.A.U. does not offer any guarantee, expressly or implicitly, in relation with the information shown in this document.

All terms, conditions and prices contained in this document are merely informative and subject to modifications depending on the market circumstances, changes in laws, jurisprudence, administrative procedures or any other issue which may affect them. The customer should be aware that the products mentioned in this document may not be appropriate for his/her specific investment targets, financial situation or risk profile. For this reason the customer must make his/her own decisions by taking into account such circumstances and by obtaining specialized advice in tax, legal, financial, regulatoy, accounting issues or any other type of information required.

March Gestión de Fondos, S.G.I.I.C., S.A.U. does not assume any responsibility for any direct or indirect cost or loss which may result from the use of this document or its contents. No part of this document can be copied, photocopied or duplicated in any way or through any means, redistributed or quoted without a previous written authorization by March Gestión de Fondos, S.G.I.I.C., S.A.U.

Please note this document has been translated for your information only. In case of any errors or misinterpretations, the Spanish text will always prevail.

etfs, etps, and passive management: unmitigated risks? · 2018-03-09 · etfs, etps, and passive...

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