Tagged: ETFs

Green and Purple

I can’t find a team (men’s or women’s) headed to March Madness, the annual collegiate sports fete in the USA, wearing green and purple. But the market’s awash in them.

Don’t you mean red and green, Tim?  Buy and selling?

No, green and purple.  See this image?  Green and purple are Passive Investment and Risk Management, a combination revealing how arbitrage in Exchange Traded Funds (ETFs) is taking over the stock market.

In the first circle, green and purple coincide with short covering (lower bar graph) and a surge in price.  In the second, green and purple again, shorting up, price falls.  It’s an anonymous stock exemplar but we see these patterns everywhere.

Monday, a friend sent me a note: “First thing I heard today when I got in the car to go to work and turned on the news is ‘Dow is down on fears of Trump tariff.’  Now I see the market is up 400 points. Should it say: ‘Markets up on Trump tariff?’”

Some pundits, coughing in advance, said it was reduced fears of tariffs on Canada and Mexico. It may be the green and purple gang and not rational thought at all.

I’ve written before about the “arbitrage mechanism” for ETFs.  Google “ETF arbitrage mechanism.” It’s presented as a good thing – the way ETFs can closely track an index.

Yet apart from ETFs, regulators, congresspersons, pundits, investors, all rail at “the arbitragers” for distorting prices and manipulating markets.  Isn’t it cognitively dissonant to say it’s good for ETFs but bad elsewhere?

If we don’t know what’s pricing the market because a pervasive “arbitrage mechanism” – green and purple going long and short – trumps Trump tariffs or any other fundamental consideration, the market cannot serve as a reliable barometer for corporate effort or economic activity.  I’m surprised it’s not troubling to more.

For every trade executed in the stock market in December, 19 were cancelled before matching according to Midas data from the SEC.  Of those that completed, 30% were odd lots – less than 100 shares (no wonder average trade size is about 180 shares).

Trade-cancellations in ETFs run about four times higher than in stocks, near 80-to-1, Midas shows. If trading motivation is changing the price, cancellations will run high.  Investors don’t do it. Profiting on price-differences is arbitrage. Only 5% of US stock orders execute, suggesting a lot of arbitrage. It’s rampant in ETFs. Green and purple.

Here’s what I think. Brokers trade collateral like stocks and cash at a fixed, net-asset-value to ETF sponsors tax-free for ETF shares. They cover borrowed stock-shares, bet long in futures and options on the indexes and components and sell ETF shares to investors.

When the group or index or sector or market-measure has appreciated to the point the ETF sponsor will incur taxes on low-basis stocks in the collateral the brokers provided, the brokers short those stocks and the options and futures and buy the ETF shares and return them to receive the collateral back in exchange.

Headlines may create entries and exits. This process repeats relentlessly, prompting investors and pundits and companies to draw widespread false correlations between market behavior and fundamental or economic factors.

It’s a genius way for brokers, traders and fund sponsors to make money. One could say we all benefit by extension. To a point, yes. So long as more money comes into the market than leaves it, stocks rise.

Volatility mounts on over-correction, where the arbitragers cover at the wrong time, short at the wrong time or exchange collateral for ETF shares in ill-timed ways, leaving puzzled people watching the tape.

Upon reflection, I guess it’s a good thing no team is wearing green and purple. The rest of us would do well to get as good at pattern-recognition as we are at PE ratios, because the patterns are setting prices. Watch the green and purple.

Collateral Recovery

Who remembers EF Hutton?

When EF Hutton talks, people listen.  That slogan crafted by Hutton’s William Clayton, who died in 2013, and now-defunct advertising agency Benton & Bowles, wasn’t about a man but a firm. Ads ran in the 70s and 80s where characters would shout “EF Hutton!” over a din, and all clamor would stop as people leaned in to hear.

Edward Francis Hutton died in 1962. But his firm touched history via its brand, its merger with Shearson Lehman, and its subsequent mutations through Smith Barney, Citigroup and Morgan Stanley. The name lives today, in fact, through HUTN Inc., which owns the EF Hutton moniker.

In a sense the Hutton Effect today in capital markets is Amazon. Every time Amazon speaks, the market holds its breath.  From athletic apparel, to groceries, to pharmaceuticals and healthcare, the market has stopped midsentence, transfixed. Investors realize Amazon is so leviathan (searching for a synonym for “Amazon”) that it can sway the fortunes of industries.

Another mammoth in our midst seems to go unnoticed, a sort of antonym to EF Hutton and Amazon. Exchange Traded Funds.

NOTE: I’m on a panel tomorrow for the NIRI Virtual Chapter on Passive vs Active Investing and will serve as warmup or foil Thursday Feb 22 for NIRI CEO Gary LeBranche here in Denver at the Rocky Mountain chapter, on ETFs.  We’ll talk about ETFs.

ETFs have been loud about attracting $4.8 trillion of global assets and 50% of US trading volume, but dead quiet about what they really do. Were sellers of groceries thrown in a pit with a hulking sword-swinging Amazon, the cries would be shrill. A market tossed together with this beast called ETFs offers not a whimper, let alone a silence-deafening EF Hutton listen.


I’ve come to an answer.  We know how Amazon works.  Whatever you think of the Bezosian Beast, we understand its manners.  It’s among us without guile.

But I don’t think investors and public companies get what ETFs do. They are a permeating market presence of epochal significance and yet an idea persists that their influence is invisible. It’s not true with Amazon, or ETFs.

Suppose ETFs through the use of collateral drove these recent gyrations?  There’s a swamp around the way they work. Read the prospectus – not the summary but the full document – for SPY. Tell me what you learn.  Half of it is about taxes.

But I know this: ETFs don’t invest your money. They manage collateral. Big investors gather up shares in large blocks from who knows where, because there’s no transparency, and exchange them for ETF shares.

They then sell those ETF shares at a profit. Don’t believe me? Read an ETF prospectus.  What’s this got to do with market volatility?  Suppose big investors had pledged stocks belonging to others as collateral to gain access to ETF shares expected to rise in value – and then the collateral dropped sharply in value.

They’d have to sell assets to raise money to buy ETF shares to trade back for collateral that might well belong to somebody else (never pledge the mob’s donkey on your personal horse race).

Boy would that process produce volatility if it were Amazonian in scope. And volatility was leviathan. Collateral damage.

Theorizing this way, we warned clients last week (as those of you reading know): If this is sorting out who owns what, we’ll take a hit Tue-Wed Feb 20-21.

Okay, well, that happened yesterday.  A glancing blow but it was there. If collateral is sorted out, markets zoom anew now. If not, you’ll see trouble again today.

Lesson? We can see what Amazon is doing. ETFs are another story.  We don’t know what they use for collateral. That alone should make us more watchful. ETFs don’t behave like EF Hutton stilling the noisy room.

So stay tuned. If this is a collateral recovery, confidence may be shaken. And we all need to understand the Amazon of the capital markets, ETFs.

Vapor Risk

One definition of “volatile” is “passing off readily in the form of vapor.”

Through yesterday, XIV, the exchange-traded security representing a one-day swap from Credit Suisse and offered by VelocityShares, had seen 94% of its value vaporized. It triggered a technical provision in the fund’s prospectus that says Credit Suisse may redeem the backing notes if the fund loses more than 80% of its value. It’s shutting down.

By mixing exposure to futures and other derivatives of varying lengths tied to the S&P 500, XIV aims to let investors capture not the appreciation of stocks or their decline if one shorted them, but instead the difference between current and future prices. Volatility.

The fund says in sternly worded and repeating fashion things like: The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day.

The idea for investors is hitting the trifecta – long rising stocks, short falling stocks, and with things like XIV, capturing the difference between prices to boot.

The problem for “synthetic” exchange-traded notes (ETNs) like XIV backed by a Credit Suisse promissory note is they hold no assets save commitment to replicate an outcome. They are for all intents and purposes vapor.

They have proved wildly popular, with several volatility ETNs routinely in the top 25 most actively traded stocks. In a low-volatility environment, differences in prices between short-term and long-term options and futures can mean returns of 5-10% on a given day, without particular risk to either party.

But if volatility renders futures and options worthless because prices have changed too much, all the investor’s capital vanishes.

Is this what rocked stocks globally? No. There is, however, a lesson about how global financial markets work that can be drawn from the demise of XIV.  Everyone transfers risk. Investing in volatility is in a sense a hedge against being wrong in long and short positions. If you are, you still make money on the spread.

The biggest risk-transfer effort relates to currencies and interest rates. As with stocks, the transference of unexpected fluctuations through swaps – which the Bank for International Settlements says have $540 trillion of notional value (but precious little actual value, rather like XIV) – only works if the disturbances are small.

In the past month, the US Treasury was laying in dry powder before the debt ceiling. The size of auctions exploded by about 50%. Getting people to buy 50% more of the same thing caused interest rates to shoot up. The rise in debt devalued the dollar, a double whammy. Hedges fell apart.

Counterparties for these hedging swaps also transfer the risk, often with short-term Exchange-Traded-Fund (ETF) or ETN hedges that lapse on Fridays. They are the same banks like Credit Suisse making markets in stocks. This is what caused stocks to swoon, not a strong jobs number or higher wages. On Friday, Feb 2, stocks imploded. I suspect counterparties were selling assets to cover losses.

Now we come to a warning about ETFs. Their original creators, who were in the derivatives business, likened ETF shares to commodity warehouse receipts, a representation of something physically residing elsewhere.

In this long bull market, money has poured into ETFs. The supply of things in the warehouse has not kept pace with the exposure to it via ETFs.  We have written over and over about this problem. The way ETFs trade and the way underlying assets increase or decrease are two different processes.  Investors buy and sell the warehouse receipts. The fund and its Authorized Participants in large block transactions occasionally adjust underlying warehouse assets.

We can see by tracking the amount of money flowing to big ETFs from Blackrock, Vanguard and State Street and counter-checking those flows against reported fund turnover that insufficient warehouse commodities (stocks) back ETF shares.

Why? Because buying and selling things incurs transaction costs and tax consequences, which diminishes fund performance. Shaving those is a gutsy strategy – sort of like dumping fuel in a car race to give yourself an advantage in the last flaps by running light and on fumes.

But you can run out of fuel. If the value of the stuff in the warehouse plunges as everybody tries to sell, we’ll find out what part of those warehouse receipts are backed by vapor.

So far that has not happened. But we don’t know what damage has been done to market makers short ETF shares and long stocks or vice versa. The next week will be telling. If a major counterparty was irreparably harmed, we could be in a world of vapor.

If not, the hurt will fade and we’ll revert to normal. Right now, forecasts for stocks in our models say vapor risk is small. But let’s see what happens come Friday, another short-term expiration for derivatives.

The 5.5 Market

The capital markets are riven with acronyms.

One of the first you learn in IR (acronym for investor relations) is “GARP.” Growth at a Reasonable Price.  As 2018 begins, GARP is a great way to describe the stock market, just as it was in 2017. Will it continue?

Let’s set ground rules. What “reasonable” means varies with circumstances but the idea is you’re paying a fair price for appreciation, what investors want and companies hope to deliver.

If arguments were colors, you could hear every hue of the rainbow on whether stocks are overpriced or not. Here at ModernIR, we’re statisticians studying how money behaves. We measure what it’s doing rather than whether it should be doing what it’s doing.

What I’ve learned from observing data is that there is an elegant and uniform explanation for why we have a GARP market. I’ll come to it in a moment.

But to ModernIR GARP is a number: 5.5/10.0 on the ModernIR Behavioral Sentiment Index.  Take the FAANGGs – Facebook, Amazon, Apple, Netflix, the two Alphabets. For 2017, the ModernIR BSI is 5.44 for them. The Russell 1000 is 5.48.  The BSI comprised of our client base with more energy and telecom is 5.39 for 2017.

As 2018 begins, it’s 5.6. All these numbers are within two-tenths of a point. It’s a GARP market.

It means it’s a little better than neutral, which is GARP investment.  For instance, if an economy’s population grew, and the ratio of people employed remained constant, and purchasing power outpaced inflation, you’d have a GARP economy.  Buying and holding it would mean appreciation.

Don’t think too long about that one. You’ll become disturbed by incongruity – but that’s a separate story. We’re after an elegant and uniform explanation to why our market runs according to GARP.

CNBC’s Jim Cramer believes it’s this: “There aren’t enough shares!!!”

It’s a point we’ve made too.  Both the number of companies in the US stock market and the total number of outstanding shares has been in steady decline while the amount of money chasing the shrinking product pool continues to rise.

Is inflation the elegant explanation? More money chasing fewer goods? Discounting fundamentals entirely seems incorrect.

But money chases the goods, and what form is money taking? A passive form. Statistically, 100% of the net inflows to stocks the past decade have gone to index and exchange-traded funds. Over that time, stock pickers have lost trillions.

Therefore, the money chasing the goods is pegging a benchmark, not picking outperformers. And by far the big winner is ETFs. What can ETFs do that no other investment vehicle can? They can substitute shares representing stocks, so they don’t have to buy or sell them like other investors do.

More ETF shares are created to accommodate inflows, and then destroyed during outflows, so ETFs bob on the surface of the market, which otherwise fluctuates with supply and demand.

And since all the new money is using ETFs, the entire market has become the bobber.  ETFs create the capacity for ever more money to have access to the same underlying goods. And that is why the market is up, all other things being equal.

It struck me over the holidays that the structure of ETFs, which depends on arbitrage – profiting on price-differences – would inevitably produce a declining market IF the number of shares or public companies or both were expanding. Arbitrage would consume appreciation, leading to an investor exodus from ETFs.

Thus, the elegant explanation for our GARP market is that ETFs arbitrage stocks back to the mean, which is 5.0, and rising flows of capital and shrinking numbers of public companies combine to breed a 5.5 market. GARP.

Why? Because there are ever more ETF shares to accommodate flows to ETFs. For stocks it means multiple-expansion, since ETFs, unlike IPOs, do not create shares of more value-creating enterprises. They only give more money access to the same stocks.

What stops it? The same thing that haunts the global currency system. If at any point, global currencies stop expanding, the prices of all assets could plummet. Why? Because expanding currency supplies drive up prices and create credit, so people keep borrowing more money to buy things. If that process freezes up, prices will implode. Witness 2008.

For ETFs, the danger is as simple as a market in which inflows stop.  What would cause that?  I don’t know right now!  But for the moment it’s not something to fear. We’re in a GARP world.

Supine Risk

We’re in New York this week while companies gather in Dallas for the annual NAREIT conference, the association for real estate investment trusts.

Real estate is about 3% of the S&P 500. By comparison, Technology is 23%, the largest by a wide margin over healthcare and financials (a combined 27%).  Yet large REIT Exchange Traded Funds hold more assets than big Tech ETFs, with the top ten for each managing $54 billion and $46 billion respectively.

The implication is disproportionate influence in real estate from passive investment. With market sentiment the weakest in more than a year by our measures, I’m prompted to reflect on something we’ve discussed before: Risk in passive investment.

One might suppose that investments following models are less risky than portfolios built by selecting stocks on fundamental factors. Singling out businesses leaves one open to wrong decisions while baskets diffuse risk. Right? Look at Vanguard’s success.

Yes. But missing in these assumptions is what happens when concentrated assets are bought and sold. The biggest real estate funds are mainly at Vanguard, Blackrock, State Street and Schwab. It’s probably true across the whole market.

Behind ETFs, stocks are concentrated too. We’ve described how the top thousand stocks are more than 90% of market volume, capitalization and analyst coverage. Just 8% of assets are in the Russell 2000, the bottom two tiers of the Russell 3000. And there are barely more than 3,300 companies in the Wilshire 5000 now.

Lesson: Everything is big. One reason may be that money buys without selling. Inflows are topping outflows (hint: That has now stopped for the first time in over a year), so indexes aren’t paying out capital gains, skewing returns, as Jason Zweig wrote in the Wall Street Journal Nov 10.

Mr. Zweig highlights the PNC S&P 500 Index Fund, which is distributing 22% of assets as a taxable gain because people have been selling it.  The fund has performed about a third of a percent behind peers. Add in capital gains and the sliver becomes a maw.

Mr. Zweig notes that some big funds including the Vanguard 500 Index and the State Street Institutional S&P 500 Index Fund haven’t paid out capital gains in more than 15 years. If investors aren’t cashing out, assets aren’t sold, capital gains aren’t generated, and results don’t reflect underlying tax liability.

To me there’s a bigger passive risk still. With more money chasing the goods than selling them, things perpetually rise, turning investor-relations professionals and investors alike into winners, but begging the question: What happens when it stops?

I’ve always liked Stein’s Law as a bellwether for reality. If something cannot last forever, said Herb Stein, father of famous son Ben, it will stop. Since it cannot be true that there will always be buyers without sellers, the prudent should size up what happens when giant, concentrated owners shift from buying to selling.

To whom do they sell?

And how can we have buyers without sellers?  Mr. Zweig talks about that too, indirectly. We’ve written directly about it (and I’ve discussed it with Mr. Zweig).  Indexes and ETFs may substitute actual shareholdings with something else, like derivatives. If you can’t find an asset to buy, you buy a right to the asset. This idea torpedoed the mortgage market. You’d think we’d learn.

There’s a rich irony to me in equities now.  During the financial crisis, regulators bemoaned the long and risky shadows cast by giant banks too big to fail because failure would flatten swaths of the global economy.

That was just banks. Lenders.

What we’ve got now is the same thing in the equity market, but risk has transmitted to the assets we all depend on – not just the loans that leverage dependency.

It’s the most profound reason for future policymakers (Jay Powell and Steven Mnuchin) to avoid the mistakes made by the Bernanke Generation of central bankers, who depressed interest rates to zero out of frantic and preternatural fear of failure.

The absence of reasonable interest rates devalues money and pushes it into assets at such a profound rate that for very long stretches the only thing occurring is buying. Result: Everything is giant, and concentrated – the exact opposite of the way one diffuses risk.

When it stops there are no buyers left.

How to get out of a problem of this magnitude?  Quietly. If enough people tiptoe away, there will be buyers when everything is properly priced again.  The hard part is knowing when, because passive risk reposes supine.

Half the Market

I’ve seen at least four Wall Street Journal stories in May alone about a quiescent VIX.

The CBOE’s volatility index derived from options pricing on the S&P 500 hit a low Monday last seen in Dec 1993, the WSJ said (subscription required). It moved lower still yesterday, 9.58 intraday.

Implicit in the storyline is a bull market, since one roared from 1993 to the bursting of the dot-com bubble. But the conclusion violates the Law of Small Numbers, the human propensity to assign undue value to insignificant data sets.  As proof, the VIX was a hair’s breadth from record low in Jan 2007.

Remember that? Lehman, little did we know, was failing. The financial crisis thereafter manifested in markets like a Hollywood blockbuster action movie where the hero outruns the explosion as the structure dissolves in showering computer-generated fantasia.

Since we can make equal bull or bear cases with the same data, it supports neither.

Aside: The investor-relations profession has a notorious proclivity toward the Law of Small Numbers. Stock’s down 3%, so we call somebody to learn why. You’re chasing the exception. Track instead the central tendency in the whole data set so you can see what changed before the stock fell 3%.

And assigning rational motivation to the VIX defies the data.  Less than 20% of daily market volume comes from rational thought. The rest is tracking the mean, arbitraging spreads back to the mean, or hedging departures from the mean.

Where everything is average, volatility vanishes. Thus a dead VIX fits. It offers little predictive value (save higher volatility always follows very low) and simply points to low spreads.

The reason is market structure. Passive investment tracks benchmarks and so seeks the mean – average price. Arbitragers look for departures from the mean to trade for profit. The market is riven with arbitrage so few mean-divergences survive to the close. But boy is there opportunity. You’ll see soon.

Meanwhile, those managing risk offload exposure to someone else, which produces equal and offsetting trading – which reinforces the mean.

And here’s a shocker. We track daily share-borrowing – shorting – as a percentage of total trading volume. Short shares are 48.1% of volume, which means long trades are 51.9%. In other words, nearly half the market is short.

Locked markets, or trades where the bid to buy equals the asking price to sell, are prohibited, so there will always be a spread, a dab of volatility. Arbitragers are almost guaranteed gains by being long and short everywhere.

We also measure intraday volatility, the spread between average intraday high and low prices. It’s 2.5% – astonishing arbitrage fodder.

For perspective, the S&P 500 rose 0.5% the last ten sessions. That means stocks are 400% more volatile every day than the ten-day change in closing prices.

Arbitragers are making tremendous gains by consuming intraday volatility.

It may be that Exchange-Traded Fund (ETF) market-makers are responsible. It explains why ETF costs are so low: Arbitrage gains are additive.

And ETF sponsors can rent out liquidity, shares accounting for the 48% of trading that’s borrowed – boosting returns. There’s support in the data. We track passive-investment patterns and correlate them to short volume, and there’s agreement.

ETF market-makers have four arbitrage opportunities: a) ETF net asset value versus ETF price; b) ETF versus underlying index; c) ETF price versus prices of components of the index; d) ETF price versus options and futures on components and the index.

By the close, ETFs and indexes want to peg the measure so divergences converge at average.

It’s a circumstantial case. But evidence piles up that ETFs are consuming spreads while simultaneously driving stock-prices and deflating the VIX.

What’s the risk?  Mortgage-backed securities did the same thing to real estate.  There was a finite asset, homes. With cheap mortgages, lots of money wanted exposure. So home loans were securitized – replicated – to expand demand, delivering great returns to those selling them. It worked till home prices stopped rising. Then replicated value evaporated. Half the market.

There are less than 3,600 US public companies when ETFs, multiple share classes and closed-end funds are removed. Low rates have created high demand. To expand access, ETFs replicate exposure, and are booming. It works so long as stocks rise.

When that stops at some sure point, extrapolated value will be marked to zero. Half the market.  Won’t arbitragers save the day? Not if volatility jumps as average prices plunge.


The point isn’t that Blackrock picked robots over humans.  The point comes later. 

If you missed the news, last week the Wall Street Journal’s Sarah Krouse reported that Blackrock will revamp its $275 billion business for selecting individual stocks, turning over most decisions to machines (ejecting scores of human managers).

For perspective, that’s about 5% of Blackrock’s $5.1 trillion in assets. The other 95% is quantitative already, relying on models that group stocks around characteristics ranging from market capitalization to volatility.

Spanning 330 Blackrock iShares Exchange-Traded Funds (ETFs) are 14 primary clusters of characteristics that define investments. What Blackrock calls its “core” set are 25 ETFs managing $317 billion, more than the entirety of its active stock-picking business. Core investment describes what Blackrock sees as essentials for a diversified portfolio.

Blackrock views investing as a mixture of ingredients, a recipe of stocks.  The world’s largest asset manager thinks it’s better at crafting recipes than picking this or that flavor, like Fidelity has done for decades. 

But who is most affected by the rise of Blackrobotics?  We come to the point.  Two major market constituencies are either marginalized or reshaped: Public companies and sellside stock researchers.

“Sellside” means it’s the part of the market selling securities rather than buying them. Blackrock is on the buyside – investors who put money into stocks. The sellside has always helped investors by keeping stocks on hand like Merrill Lynch and Morgan Stanley used to do, and processing stock trades.

The sellside since brokers first fashioned the New York Stock Exchange also armed investors with valuable information through stock analysis. Analysts were once the big stars wielding power via savvy perspectives on businesses and industries. Everybody wanted to be Henry Blodget talking up internet stocks on CNBC.

Following the implosion of the dot-com boom of the 90s, regulators blamed stock analysts and enforced a ban on the use of valuable research preferentially, a mainstay for brokers back two centuries. So the sellside shifted to investing in technology rather than people, and the use of trading algorithms exploded.

Brokers – Raymond James to Credit Suisse, Stifel to JP Morgan – have long had a symbiotic relationship with public companies. Brokers underwrite stock offerings, placing them with their clients, the big investors.  After initial public offerings, analysts track the evolution of these businesses by writing research and issuing stock ratings. 

That’s Wall Street.  It reflects the best symbiosis of creative energy and capital the world has ever seen. Analysts issue ratings on stocks, and companies craft earnings calls and press releases every quarter, and money buys this combination. The energy of it hisses through the pipes and plumbing of the stock market. 

Blackrock uses none of it. It’s not tuning to calls or consuming bank research. Neither does Vanguard. Or State Street. Together these firms command some $11.5 trillion of assets eschewing the orthodoxy of Wall Street.

Public companies spend hundreds of millions annually on a vast array of efforts aimed at informing stock analysts and the investors who follow what they say and write. Earnings calls and webcasts, websites for investors, news via wire services, continuous travel to visit investors and analysts.

It’s the heart of what we call investor relations.

What Blackrobotics – Blackrock’s machines – mean to public companies is that some effort and spending are misaligned with the form and function of the market. It’s time to adapt. The job changed the moment Vanguard launched the first index fund in 1975.  You just didn’t know it until now. 

How do I change it, you ask? You can’t. Public companies should expend effort proportionate with the behavior of money. The trillions not tuning to calls or reading brokerage research deserve attention but not a message.

If money is using a recipe, track the ingredients and how they affect valuation, and report on it regularly to management. Get ahead of it before management asks.

It’s neither hard nor scary. What made index investing a great idea, to paraphrase Vanguard founder Jack Bogle, was that it was difficult for investors to be disappointed in it.  Same applies to IR and passive investing. What makes data analysis alluring is that it’s a management function and it’s hard to be disappointed in it.

(Note: If you want help, ask us. We use machines to measure machines and it’s simple and powerful and puts IR in charge of a market run by them. I talked about it yesterday at the NIRI Capital Area chapter).  

I’m not sure how capital forms in this environment. Wall Street lacks plumbing. Thus, companies grow privately and become index investments via IPOs, exiting as giants that are instantly part of the thousand biggest in which all the money concentrates.  

It’s not the end of the world, this rise of the machines.  But Blackrobotics come at a cost.  We all must adapt. It’s far less stressful embracing the future than missing the past.

Market Serfdom

Last week a stock strategist said passive investment is worse than Marxism.

That’s a way to get attention at risk of offending Marxists. It did (get attention). CNBC covered it. Jason Zweig did too in the Wall Street Journal weekend edition.

It’s relevant to investor relations because passive investment is sweeping the planet. We call it “the elephant in the room” because public companies sometimes seem paralyzed as mass capital inured to the sellside and results and road shows floods stocks.

The shift is huge. Mr. Zweig noted that in the past year $300 billion left active stock-picking portfolios as $400 billion flowed to indexes and exchange-traded funds.  Over the trailing decade, data from the Investment Company Institute show it’s trillion of dollars routing from active funds to passive vehicles.

You’ve seen the Betterment ads?  This “robo advisor” let’s investors precisely tailor exposure to various assets the same way architects use CAD systems to design structures.

At Sanford Bernstein in London, senior analyst Inigo Fraser-Jenkins released a report borrowing economist Friedrich Hayek’s phrasing called “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” I thought immediately of “The Princess Bride” as I’d never encountered anyone named Inigo save Montoya (Mandy Patinkin) in that film pursuing the six-fingered man.

Mr. Fraser-Jenkins, erstwhile head of quantitative strategy at Nomura, thinks the six-fingered threat from passive investment is its lack of judgment for committing capital.

Brilliant point. The equity capital market formed so people with money could take risks on businesses that might improve the human lot.  The brokers pooling capital then supported these endeavors with research so investors could make informed decisions.

Enter Blackrock and Vanguard. No, they’re not Trotsky and Lenin papered in currency. But they’re massive through efficiency, market rules, monetary policy (a system, not good judgment, makes it work), not prowess or wisdom.

Mr. Zweig says Vanguard reported owning 6% of all US shares. Assume Blackrock is about 7%. Combined, they’re 10-15% holders of everything. Dictators.

“What happens when everybody indexes?” John Bogle, Vanguard founder, said to Mr. Zweig.  “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.”

Mr. Bogle adds that we’re a long way from there.  Indexes would have to grow to 90% of the market from between 5-10% now. Oh? We’ll come back to this point to conclude.

When money is directed by a model to equities, there’s a shift in purpose from giving to taking.  How? Models take a piece. Investors commit.

The market first formed so entrepreneurs needing risk-taking capital could find it. A market priced around the willingness of investors to accept risks combined with the capacity of businesses to deliver results is the heartbeat of efficient capital-allocation.

Models don’t care about that relationship. They take, then leave. So invention happens on private equity, which removes from the American capital model its defining egalitarianism for the masses and instead concentrates it in ever fewer hands.

Your job just took on added importance, IR pros. You alone can track the impact and evolution of asset-allocation. Move beyond telling the story to measuring quantitative investment. It’s the job of IR to apprise executives and boards of important facts about the equity market.  It’s our market. No index will tell you something is amiss.

So The Elephant slouches toward serfdom.

In that shadow, any company considering itself a yield investment has Big Data looming tomorrow after the close. Most REITS will separate into a new industry classification from Financials.  That’s like a massive index-rebalance playing out over coming weeks.

Concluding, Mr. Bogle is wrong about how much bigger indexing can get before markets are paralyzed.  We’re now pushing limits. Indexes and ETFS are currently 32-33% of daily volume, combined (our measures). At 40% there will be no room for anything but machines. Stocks are needed to satisfy stock-pickers, fast traders, counterparties for derivatives and trading leverage. It’s already so finely balanced that most stocks don’t trade more than 200 shares at once.

You’re the frontline, IR. This is your fight. Report on it (we can help). Solution? Remove rules making averages the goal. Stock-picking would soar anew.  Else? Serfdom.

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Janus ETFs

Everybody adapts, including institutional investors like Janus.

Rattle off a top-ten list of the best active stock pickers visited by teams of company execs and investor-relations pros trundling through the airports and cities of America, and Denver’s Janus likely makes the cut.

Ah, but.  In 2014 Janus bought VelocityShares, purveyor of synthetic exchange-traded products.  Just as a drug manufactured in a laboratory rather than from the plant that first formed its mechanism of action is a replica, so are these lab-made financial instruments. They replicate the act of investment without actually performing it.

It’s neither good nor bad per se, as I explained yesterday to the NIRI San Diego chapter. But synthetics are revolutionizing how public stocks trade – without owning public stocks. Describing its effort at adaptation, Janus says on its website that it’s “committed to offering distinctive strategies for today’s complex market environment. Leveraging almost a half century of investment experience, we are now pleased to make our expertise available through Exchange Traded Funds.”

Janus says it’s intending to offer a range of returns beyond simple capital-appreciation, including “volatility management” and “uncorrelated returns.” Janus’s VelocityShares directed at volatility aim to produce enhanced or inverse returns on the VIX, an index called the “fear gauge” for reflecting volatility in forward rights to the S&P 500.

But traders and investors don’t fear volatility. They invest in it.  On Monday May 16, four of the top 20 most actively traded stocks were exchange-traded products leveraging the VIX.  Those offered by Janus aren’t equity investments but a debt obligation backed by Credit Suisse. Returns derive from what is best described as bets using derivatives.

The prospectus for the most active version is 174 pages, so it’s hard to decipher the nature of wagers. It says: “We expect to hedge our obligations relating to the ETNs by purchasing or selling short the underlying futures, listed or over-the-counter options, futures contracts, swaps, or other derivative instruments relating to the applicable underlying Index…and adjust the hedge by, among other things, purchasing or selling any of the foregoing, at any time and from time to time, and to unwind the hedge by selling any of the foregoing, perhaps on or before the applicable Valuation Date.”

Got that?  Here’s my attempt at translation: “We’ll do the exact opposite of whatever return we’ve promised you, to keep from losing money.”

During the mortgage-related financial crisis there was a collective recoil of horror through media and into Congress that banks may have been betting against their clients. Well, come on.  It’s happening in equities every day!  Exactly how do we think somebody who says “sure, I’ll take your bet that you can make double the index without buying any assets” can possibly make good without farming the risk out to someone else?

In the mortgage crisis we learned about “credit default swaps” and how insurers like AIG were on the hook for hundreds of billions when real estate stopped rising. Who is on the hook for all these derivatives bets in equities if stocks stop rising? It’s the same thing.

Last Friday the 13th, five of the top 20 most actively traded instruments on the Nasdaq and NYSE were synthetic exchange-traded products attempting to produce outsized returns without correlating to the market. That’s 25% of the action, in effect.

For stock-picking investors and public companies it means a significant contingent of price-setting trades in the stock market are betting on moves uncorrelated to either fundamentals or markets. You’ll find no explanation in ownership-change.

What do you tell management and Boards about a market where, demonstrably, top price-setting vehicles like TVIX owned by conventional stock-pickers aren’t buying or selling stock but betting on tomorrow’s future values using derivatives?

In fact, everyone is betting against each other – traders, banks, investors. I take you back to the mortgage-backed securities crisis. The value of underlying assets was massively leveraged through derivatives the values of which bore no direct connection to whether mortgages were performing assets.  That by any definition is credit-overextension. A bubble.  A mania. Then homes stopped appreciating. The bubble burst two years later.

Look at stocks. They’ve not risen since Nov 2014. Is anyone out there listening or paying attention to the derivatives mess in equities?