Tagged: Indexes

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.

Blackrobotics

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.

A Rational Market

The market appears to have become the Walking Dead.

I don’t mean a collection of bodies reduced to bloody pulp by a barbed-wire encased baseball bat. That would be the Presidential election. (Aside: you who watched the new Dead episode know with nauseating certainty what I mean.)

No, market volume is a zombie compared to the summer. Volume was 6.7 billion daily shares Jun-Aug 2016.  Now we’re eking out 5.8 billion, a drag-footed, scar-faced amble.

Usually it’s the other way around.

Meanwhile, business media has been fixated (somewhat ironically) on the Passive invasion that’s digging a giant hole and burying stock-pickers. The Wall Street Journal last week ran a half-dozen stories on the death-grip indexes and exchange-traded funds have laid on investing. Not to be outdone, CNBC covered the big lurch into market passivity all last week.

Both reported how Blackrock has amassed $5 trillion of assets (while, we’d add, ignoring the sellside, discounted cash-flows and earnings calls).  A WSJ article titled Passive Can Be Very Active described how leveraged ETFs classified as passive vehicles drive immense daily volume (we told you about these things a long time ago).

But volume is moseying. So wither the wither?  It looks like Passive is responsible. Now, the market is a uniform beast in which every barcoded thing must behave like the rest or regulators fine it for looking different, by which I mean failing to trade at the averages. If any stock so much hints at departing from the crowd it’s immediately volatility-halted.

I exaggerate for dramatic effect but only some. Rules create uniformity that makes standing out difficult. So over time stocks cluster around the averages like, well, zombies. The world’s most widely traded equity by a country mile is SPY, State Street’s ETF proxy for the S&P 500.  It routinely manages $25 billion of daily volume.

But that was last summer. Monday with the November series of options and futures trading marketwide – routinely it’s hectic with new derivatives – it managed about $11 billion, just 45% of its summertime tally.

We measure the share of daily volume driven by Passive investment marketwide. It’s not down a lot, 100 basis points or so. But that’s every day. And it ripples into options and futures that counterparties back with equity-trading as placid measures mean indexes and ETFs use fewer of them to true up positions. Weaker Fast Trading follows, and anemic ETF market-making. Pretty soon it’s the walking dead.

But there’s a storyline of survival. While the corpus of passivity has shriveled like bacon in a hot pan, or perhaps more accurately like one of those flex hoses when you shut the water off, underneath there is a turgid Active current.

I mean Active investment. We’re a data-analytics firm so we measure everything.  We know each day what percentage of our clients earn new Rational Prices (fair value) when Active stock-pickers buy.

Amidst listless Passive volume, we have seen surging Rational Prices.  On Oct 13, a stunning 32.7% of our client base had new Rational Prices even as volume wilted like pumpkin leaves after the first frost.

Last Friday, the 21st, the penultimate Friday before Halloween and fittingly hosting triple-witching, an impressive 15.5% of our clients were valued rationally by Active investment.

There’s a post-mortem here, a timeless market-structure lesson. First, volume that’s not Rational distorts fair value. Stuff that pursues averages hurts stock-pickers.

And if volume decreases while Active Investment improves its price-setting authority, volume does not equal value.  What matters is the kind of money setting price. With less competition from zombies, the enterprising can make supply runs.

That’s really great news for the investor-relations profession. Our civilization will endure. You don’t need big volume. In fact, if you have big volume the old convention that “you have a big holder buying or selling” is more often wrong than right.  Active money doesn’t want others to know it’s buying. If it does, you better be wary. That’s what Activists do.

There’s more good news.  Where Passive money that puts no thought into its movement is incapable of knowing what lies ahead and can slouch unsuspecting right off cliffs, that Active money bought October brings comfort. There’s Rational Thought in that forest that so often we can’t see for the trees.

Yes, the market like the storyline in the show depends on the zombies. They move the broad measures from one point to the next. You have to be prepared for the occasional slaughter while recognizing that the humans win in the end.  Rational thought trumps.

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.

Gilding the Trend

Is index-investing the death knell for investor relations?

According to S&P Dow Jones – which, you REITs, will be breaking out your sector from Financials Aug 31, as will MSCI – over the ten years ended Dec 2015 a staggering 98% of all active investment managers in the USA underperformed the S&P 500.

These outfits are indexers and will make the case for models. But there’s an obvious rub for the profession pitching stories to stock-pickers.  If the folks listening are trailing the benchmarks, investors will move to passive investing.  And they are, in droves. If your team loses all the time, people quit coming to the games.

There’s a tendency in the IR profession to want to shove our heads in the sand about this disturbing condition.  If we can keep quiet, keep doing what we’ve done, maybe the problem will go away or management will remain unaware of it.

That’s no strategy!  Let me gild this trend in gold for the IR profession. Who is our audience?  The money.  Right?  The IR goal is a well-informed market and a fairly valued stock.  So long as you have measures (and we do here at ModernIR!) that will tell you when these conditions exist and how to keep them there, there’s no need for stress at the state of stock-picking.

Make no mistake:  Telling the story will never go away. We need the Active demographic. You have to cultivate a diverse set of styles among stock-pickers. But it can no longer be your sole endeavor. Where 25 years ago the dominant force was bottom-up investing, today’s principal price-setting investment behavior is Asset Allocation – indexes and exchange-traded funds.

Fine! So be it.  The IR profession must adapt.  We’ve seen evolution in the role over the past decade with a swath of public companies giving IR auxiliary duties ranging from communications to financial planning and analysis. Now IR must add data analysis.

Let me explain. If the money is following models, then model the money.  You can’t talk to that sort of investment about what distinguishes you.  Blackrock and Vanguard don’t listen to earnings calls. Who cares? You can track money quantitatively with a great deal more accuracy and a whole lot less work to boot than trooping all over the planet seeing stock-pickers, most of whom will fail to perform as well as SPY, the world’s most actively traded equity – which is a passive investment.

We live in a world where data and technology have converged everywhere from your kitchen to your retirement portfolio. It’s time the IR profession caught up.  Invesco owns PowerSharesJanus owns VelocityShares. The buyside is adapting. We’d better, too.

So what should you do?  The simplest, easiest and most affordable solution is to use Market Structure Analytics, which we invented to demographically profile all the money driving your equity. You can know every day what percentage of your volume is from Asset Allocation (and three other big behaviors).

Not everyone can, I realize! If nothing else, start today educating your management about ETFs.  Go to alletf.com and find out how many are associated with your shares. Explain that investments of this kind are dominating equity inflows, and consider it a badge of honor if they’ve got more than 5% of your equity collectively.

There’s a lot to grasp about ETFs. And if you’re a longtime reader you know my rub with them: They’re derivatives. Set that aside for now.  Our profession must shift from defense to offense.

It begins with leading management into the equity market we’ve got rather than letting them discover it themselves. They’ll wonder why you didn’t explain it.

Correlating Volatility

“Measure the performance of equity securities in the top 85% by market capitalization of equity securities listed on stock exchanges in the United States.”

I made it a sentence here but I clipped that phrase from a Blackrock iShares “minimum volatility” Smart Beta Exchange Traded Fund (ETF) prospectus and Googled it, and got back pages of references.  Apparently many indexes and ETFs meant to diversify and differentiate investments are built on the “top 85% by market capitalization.”

That by the way is about 700 companies. There are now over 700 ETFs in the US stock market and about 3,700 total public companies when you strip out funds and multiple classes of stock.  That’s a 1-to-5 ratio.  If many ETFs track indexes comprised of just 20% of the stocks, would that not produce high correlation?

Answer:  Yes.

I ran correlation for five ETFs from Blackrock, First Trust, Schwab, Vanguard and Invesco (USMV, FVD, SCHD, VIG, SPLV) over the past three months and it was about 90%.  Now, all five seek similar objectives so correlation isn’t surprising. But in truth they’re brewing a mixture of the same stocks.

We had the chance to participate in a wine-blending last month in Napa. The group was tasting mixtures of a core set of grapes.  What if we make it 94% Zinfandel, 3% Petit Syrah and 3% Malbec?  How about 7% Malbec, 3% Petit Syrah, 90% Zinfandel?

The same thing is happening with ETFs. They’re blending the same grapes – stocks.  What if we weight a little more than the index in WMT and a little less in AMZN?

It’s still the same stocks. And it’s earnings season.  Think about the impact of high correlation when in nearly all cases save an outlier handful ETFs track underlying indexes with defined composition.

Say you report results and your stock plunges (we’ll come to why in a moment). Even minute weighting in a falling stock can skew the ETF away from the benchmark, so the authorized participants for the ETF sell and short your shares, raising cash to true up net asset values and ridding the ETF of the offending drag.

At some future point now that your shares are sharply discounted to the group and the market, arbitragers will find you and the authorized participants (brokers creating and redeeming ETF shares to ensure that it tracks its benchmark as money flows into and out of the investment vehicle) who shorted will cover, and suddenly you’re the star again.

Neither up nor down did the behavior of your stock reflect fundamental value or rational thought. It’s high correlation, which rather ironically fosters mounting volatility. We’re seeing a notable increase in instances of large moves with earnings.  And your shares don’t drop 15% because active investors saw your numbers and decided, “Let’s destroy our portfolio returns by buying high and selling low.”

In the last week through Monday, Asset Allocators (indexes and ETFs) and Fast Traders (arbitragers speculating on intraday price-changes) were top price-setters.  Both are quantitative, or machine-driven, behaviors. One is deploying money following a model and the other is betting with models on divergences that will develop during that process.

Both create mass volatility around surprises in earnings reports. Fast Traders are the athletes of the stock market racing to the front of the line to buy and sell. Asset Allocators are lumbering, oblivious to fundamental factors and instead following a recipe.

You report.  Active investors stop their bits and pieces of buying or selling to assess your fundamentals. Sensing slight change, Fast Traders vanish from order books across the interconnected web comprising today’s stock market.  Asset Allocators tracking benchmarks stop buying your shares because you’ve now diverged from the broad measure.

This combination creates a vacuum.  Imagine selling your house and there was a bidding war for it and suddenly all the bidders disappeared. You’d have to cut your price. What changed?  The number of potential buyers, not the value of the house.

This is the problem with how a combination of Fast Traders and Asset Allocators dominate the market now.  Fast Traders set most of the prices but want to own nothing so the demand they create is unreliable and unstable.  Asset Allocators are trying to track benchmarks – that depend on Fast Traders for prices. Throw a wrench into those delicate gears with, say, a surprise in your quarterly earnings, and something will go awry.

Speaking of which, our Sentiment Index just turned Negative for the first time since February and yet the market soared yesterday.  From Feb 8-11, futures contracts behind some of the most actively traded ETFs in the market, concentrated in energy, rolled. The dollar had just weakened. Stocks roared.

The same futures contracts just rolled and the ETFs rebalanced (May 6-11). Counterparties covered. The dollar is rising. We may be at a tipping point again for stocks. Derivatives now price the underlying assets.

False Passive

Karen and I are in Boston seeing friends at the NIRI chapter (we sponsor) and our trip today like last week coincides with snow in Denver. Next winter if the slopes turn bare, we’ll schedule a couple flights to bring in the blizzards.

Last week trooping through Chicago where you had to lean to stay upright in the wind, an investor-relations officer told me, “Passive money can’t be setting prices because it’s, well, passive. It can only follow active money.”

Sometimes I’m so close to the trees of market structure that I forget about the forest everyone else is seeing. Statisticians warn about false positives, false correlations, false precision. The descriptor “passive” for investment behavior following models inaccurately portrays what the money is doing. We call it “Asset Allocation” behavior.

To understand this money let’s first review how the stock market works:

It’s a data network comprised of visible nodes called exchanges and invisible ones called formally alternative trading systems and colloquially “dark pools,” stores for stocks where you must be a member to buy. Exchanges are required to serve all customers, who must either be a broker or use one.

All markets share customers and prices. You cannot continue to serve a customer in one market including a dark pool at a price worse than what’s available elsewhere. Thus, trades must match between the network-wide best price called the NBBO – national best bid/offer (best price to buy or sell).

Orders wanting to price the market must be automated so they can rapidly move from one node to the next, or the data network can’t function.

-Because of this structure, exchanges offer trading incentives called “rebates” to more frequently have the best price on the network. They pay high-speed traders about $0.29/100 shares to bring orders to their markets and set prices.

-The NYSE, the Nasdaq and BATS Global Markets operate multiple exchanges, rather than one that would aggregate buying and selling, so as to increase the amount of time each group has the best price, which means fast traders create many prices. By our measures, fast traders are eight times as likely to set prices, but with just 100 shares.

Exchanges want to set prices because any broker or market center handling customer orders must give customers the best prices so all are required to buy expensive pricing data, which is how exchanges make money.

Now you understand the stock market. Onto this network come seas of money from Blackrock and Vanguard and a raft of exchange-traded funds. For two decades investors have been choosing passive investment in accelerating fashion. It’s how Blackrock and Vanguard are the world’s biggest investors ($8 trillion of assets) and ETFs host $3 trillion while turning holdings at 2,500% (making buy-and-hold a parody).

Passive money is governed by the model it tracks, the prospectus describing the fund, and inflows and outflows. Tack on the explosive popularity in recent years of “smart beta” money tracking mathematical measures to capitalize on trends or market inefficiencies and you have a recipe for perpetual motion.

To that end, indexed money by rule must peg its benchmark – the measure metering its performance. Indexes use options and futures to mirror the benchmark so counterparties for options and futures are in and out of the market. That sets prices.

The majority of trading in ETFs is a form of arbitrage. ETFs don’t buy or sell stocks. ETF sponsors privately transact with authorized participants in large blocks. In the market, people are trading ETF shares that simply represent assets held by sponsors. Market-makers are shorting or going long components to capture inefficiencies, and fast traders are repricing components, indexes, options and futures for spreads.

All of this is setting your price. If money flows into SPY, the world’s most actively traded stock with $25 billion of volume daily, arbitragers, market-makers and authorized participants must respond. This trade splashing through your peer group may move members disparately at times because of liquidity, options, futures, shorting.

A paradoxical cycle forms. Indices fluctuate because of arbitrage in ETFs predicated on them, which prompts indexed money to adjust, which must happen because rules for indexes demand it.

The sheer size of this money has pervasive market impact, often blotting out effort by active investors to buy or sell growth and value opportunities (uniform rules and uniform trade-executions overwhelm outlier orders, key to why stock pickers rarely beat indexes).

There’s little that’s passive about passive investment. Call it Asset Allocation. But it lacks emotion, reason and common sense. That’s why markets are unresponsive to terror attacks or flagging economies but wedded to monetary policy. It’s about the model.

Follow the Line

Money is better than poverty, if only for financial reasons.

So wrote Woody Allen for himself as Broadway Danny Rose in the eponymous 1984 film. I’m not sure what Allen meant then as I was a high-school sophomore wearing a mini-mullet. But there’s an application to IR.

Last week I had an intense exchange with an investor-relations officer new to the chair and moved over from the sellside after losing his job in research to advancing asset-allocation investment (This is Blackrock to Betterment, the translation of business strategies into squares on a Rubik’s Cube. These investors buy no research with commissions and listen to no earnings calls but track governance, meaning the biggest investors now are tuned more to rhetorical position than financial condition – I leave risk/reward ramifications to you).

Cognitive dissonance by definition is an inherent contradiction between evidence and conclusion. In Steamboat Springs it’s easy to match evidence to conclusion when watching the weather. If storms approaching from the south cross over Catamount Lake, you’re going to get showers on Mount Werner, the ski hill. Simple. No cognitive dissonance. You can see what’s happening.

But it struck me listening to this new IRO that he’d not drawn a line between his emigration from brokerage to corporate belfry. It reminded me of that lyric by Jacob Dylan, son of Bob and troubadour with the Wallflowers, who refrained plaintively how the same black line that was drawn on you was drawn on me and has drawn me in. Despite the origin of his demise on Wall Street, this IRO was certain active investors were pricing his shares. “Indexers don’t set prices,” he insisted. “They track active money.”

This view defies what we just saw from the NYSE where his shares are listed. When the exchange stopped trading for nearly half the day July 8, it was to make sure the closing cross – the ending auction setting prices for indexes and ETFs – would go off properly. The world’s greatest equity market sacrificed most of the trading day to one chronological exigency. And that’s because the most vital endeavor is tracking benchmarks – pegging the index. Getting the data right.

Follow the drawn line between diminishing sellside influence and the shift of equity research analysts to the IR chair and how the market functions. It’s drawn us all in to a 6th Avenue Heartache in a way, because what moved markets before doesn’t now, and if you suppose so, I refer you back to the definition of cognitive dissonance.

But it’s not sad! It just changes IR Best Practices – things we should all be doing. Our profession’s requisites must include comprehension of how prices are set so that the information you provide to management is accurate. Five rules:

Number One, high-frequency trading is a product of incentives paid by exchanges to fast traders to create valuable pricing data that exchanges can sell back to brokers. This is the No. 1 price-setting force (only half of intermediation is fast trading; the rest is from brokers working orders for customers).

Number Two, the buyside and sellside have spent billions over the past decade to disguise whether they’re buying or selling, so translating “block trades” into “long-only investing” doesn’t follow the money.

Number Three, the greatest force in the equity universe today is not love but asset-allocation. Blackrock and Vanguard. And they do price your shares routinely.

Number Four, more than 50% of your volume is the middle men (fast traders, brokers disguising orders) not actual investment. Factor that into your thinking.

And Number Five, there is little to no “long only” money anymore. Everybody uses a smartphone, and everybody hedges. Derivatives are a colossal factor because they represent risk-transfer and leverage and often (as yesterday in equities) price the underlying asset.

Connect the dots. Follow the money. Think. Okay, so money is no elixir and as Woody Allen said, it may be superior to poverty for financial reasons only (smile). But in the IR chair (and in politics) you should always follow it, because it’s the line of truth.

Defend Yourselves

You need to defend yourselves as public companies.

This clarion lesson comes from last week’s trading halt at the NYSE though we think the exchange handled the outage correctly. Humans want pictures of perfection like Saturday’s Balloon Rodeo in Steamboat Springs. But don’t expect serendipity in securities markets. Your equity is the backbone of your balance sheet, basis for incentives, currency for investments. Know how it trades.

The root of the NYSE’s July 8 200-minute trading penalty box is the Flash Crash, a May 6, 2010 plunge and recovery in equities that spanned about a thousand Dow Jones Industrials points in twenty minutes.  During that maelstrom, trades executed at stale prices because timestamps on orders didn’t keep pace with market activity.

Now five years later, the exchanges are aiming for a July 27 deadline on two updates to timestamps mandated by Finra and the SEC. The new timestamps will calibrate to 100 microseconds are less, with one coming from orders occurring at exchanges, and the other timestamp for ones flowing through broker-operated dark pools relying on proprietary data feeds.  The thinking here is better timestamping will improve market-function and offer better future forensics. For instance, was there separation between exchange and dark-pool prices as occurred in the Flash Crash?

You don’t have to know this in the IR chair. But what if the CEO or CFO asks? It’s the market for your shares. There’s a great deal more to it than your story, a point made stark in a moment.

The NYSE claimed it had been testing timestamps and made a mistake in a deployment. Why test new code when the Chinese market is imploding, Greece is teetering on the Eurobrink and volatility is exploding in US equities – all of it interconnected through indicative value-disseminations for global indexes and ETFs that depend on timestamps?

Be that as it may, the NYSE handled the problem appropriately by stopping trading, cancelling orders and focusing on getting operations fixed in time for the closing auction. That in itself points to the larger lesson, which we’ll articulate in a moment. We heard lots of talking heads say “our fragmented market is a plus in crises because people could continue trading.”

The outage in fact demonstrated the opposite. We measured in NYSE data that day an 18% reduction in Fast Trading generally for NYSE issues, and commensurately higher investment behavior. In other words, with trading halted for half the day, speculators were less able to interfere with real investors’ moves.

By extension, we can infer with data support that much of what occurs intraday is effort by arbitragers to spread prices among securities that must track benchmarks – market indexes – by the time trading concludes.

Guess who supports that effort? The exchanges.  I’m not castigating here. But if you’re depending on information from an exchange (or its partner) to understand your trading, you had better darned well know how the exchange operates.  When the Nasdaq charges traders to buy shares at its primary market and pays them to sell at the BSX platform, it’s helping traders multiply prices and spreads. Do you see? Paying traders to engage in opposite actions incentivizes arbitrage. All exchanges pay traders for activity that’s got nothing to do with investment.

I’ll rephrase:  The exchanges fragment markets purposely in order to sell data and create transactional opportunities. It would be akin to your real estate agent encouraging others to bid against you as you’re trying to buy a house.

The NYSE’s trading halt proved that a fragmented market harms investors and helps arbitragers, because when it was closed for three hours there was less fragmentation and more investment – but lower volume. Volume often confuses busy with productive.

Don’t track volume without also metering what sets your price! Yet that’s not the Big Lesson for public companies.  No, it’s that the single most important pricing event of the day is the closing auction. And the audience depending most on it is the one tracking benchmarks (not taking risks like active stock-pickers).  Blackrock and Vanguard – the Asset Allocators collectively and by extension.

The number one force in your market is tracking broad measures, not weighing your earnings. This money is perpetually owning and yet constantly trading to match index-movement. You must quantify the price-setting actions of this colossal demographic group. If you don’t, the intelligence you’re offering management about what’s driving your price is almost certain to be incorrect.

Defend yourselves with an objective view.  It’s part of the job. Counting on exchanges is yesterday’s way.

Quiet Midday

The midday equity-market silence is deafening.

Writing for the Wall Street Journal last week, Dan Strumpf roiled capital-markets constituents describing how stock-trading is now focused around the opening bell and the last half-hour, with volume dribbling otherwise.  NYSE strategists are now contemplating a midday auction.

Successful solutions spring from correct diagnoses. The issue isn’t that Everyone Goes Away at Midday. What’s occurring is symptomatic of structure in both the equity market and institutional investment. This is the giant elephant in the stock-market room. Concentration early and late in volumes reflects the explosive growth in passive investment.

The investor-relations profession predicates its existence on differentiating the corporate story.  You target investors appropriate for your stock. You get out there and set meetings to see investors.  You tell the story unflaggingly. You run a good business, delivering the results you’ve helped investors to expect.

Fine, good. There’s just one problem. This strategy obviates the bedrock principle of public speaking: Know your audience.  In the 1980s when stock-pickers dominated market volumes that weren’t coalesced at the open and close, rational investment behavior led and corporate competitive differentiation mattered most.

Today, the elephant is the core audience. For ten straight years investors have been shifting from picking stocks to allocating assets.  Over that time, the once-fringe notion of using statistical models to invest in stocks has become the predominant approach. Blackrock, Vanguard and their dollars by the trillions today see equities as products.

We flew to the Bay Area yesterday and after our first plane experienced mechanically related delays, we switched flights and I found myself crammed into a rear row next to a Schwab employee from the sprawling Denver office. She’s in the Registered Investment Advisor group, supporting independent planners. Schwab has now launched “robo advisor” services for both retail and advisory markets in response to growth at firms like Betterment, Wealthfront, Personal Capital, Motif Investing and others.

These automated investing services identify your preferences and goals and then construct a model to match them. In Schwab’s case the models are entirely ETF-driven and rebalance daily to match allocation targets.

Advisors could have ignored the elephant trampling the traditional model. The smart ones are embracing them. There’s a lesson for public companies: The elephant of passive, model-driven indexes and ETFs isn’t obscuring your audience. It IS your audience. This is what institutions are doing now.

That doesn’t mean you stop telling the story. It does mean that what you measure, how you gather investor feedback, what you tell management about stock-valuation and how you target investors – in fact, how you see the job – must change. We can’t ignore the giant passive-investment elephant in the room, and go on doing the same things.

Which gets back to silence at midday. Indexes and ETFs are paid to track benchmarks. Tracking is best served by orders near the close. As passive investment has exploded, volume has concentrated in the closing half-hour to mark broad measures.

The opening frenzy is also a consequence. Traders hoping to move index components for arbitrage opportunities act early in the day, leading to frenetic sprints at the bell.  And buttressing this proliferation in model-driven money is mushrooming derivatives-use, from over-the-counter options to fixed-for-floating equity swaps, all of it about the elephant in the room and arbitrage. And 44% of market volume is rented – short, borrowed – to boot.

It’s all related.  A midday auction won’t help the elephant in the room or anyone else because it hasn’t diagnosed the problem. What might help is 24-hour trading. Indexes would be relieved of the need to be near a close.  But investment would then devolve into relentless and repeating arbitrage even more than now, the continuous plucking of profits on slight separations between securities.

We could disconnect markets and disabuse ourselves of the false premise that all need the same price regardless of size – which would bring the Passive Investment juggernaut to a halt and level the playing field again for stock pickers.

That’s not going to happen. Anytime soon, at least. In the meantime, IR professionals, embrace the elephant and make measuring its movement a core part of the job because it’s your core price-setter. It’s concentrating volumes.

And that’s the quiet truth.