March 2, 2016

Inconvenience

Follow the money. Or the currency.

Yesterday markets soared on queue with a Chinese currency devaluation in the form of lower bank reserve requirements (which increases money and reduces its value). For those who at the words “currency devaluation” feel like collapsing into catatonia, resist the urge. There’s a lesson ahead.

WSJ Intelligent Investor columnist Jason Zweig described Feb 19 how active investors are using Exchange Traded Funds (ETFs). He wrote, “Picking stocks has become so hard that some stock pickers have given up pretending to try.”  One manager told Mr. Zweig he keeps 50% of his assets in ETFs because with 90% of active money trailing the averages, “half of my fund will beat 90% of managers over time.” The winning half is polling the crowd.  It’s more convenient.

The crowd today is comprised of leviathan passive investment typified by the $8 trillion held at Blackrock and Vanguard.  But that’s not what moves daily.  It’s inconvenient for Blackrock and Vanguard to maneuver massive assets like a race car through less than ten big banks executing most trades now for large institutional investors.

But investing is supposed to be inconvenient. Value that lasts should take time. Warren Buffett is 85 and began investing in his teens.  The average holding period for Berkshire Hathaway shareowners is 27 years based on annual turnover. Rome wasn’t built in a day.

Yet today’s market sells convenience. Leveraged ETFs – those using derivatives like swaps to outperform underlying benchmarks – seek one-day outperformance. From Direxion, a sponsor: “The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that may cause their price to fluctuate over time. The funds do not attempt to, and should not be expected to, provide returns which are a multiple of the return of the Index for periods other than a single day.”

In yesterday’s big market move, over half of the 25 most actively traded securities were ETFs, most of them trading more than stocks like Pfizer and GE.  Several were 3x leveraged ETFs – that is, trades designed for a single day to beat a broad measure by 200%. If your stock was up twice as much as the market, there’s your probable answer.

ETF sponsors hold assets, and big brokers called Authorized Participants create ETF shares for trading or remove them from the market to match inflows and outflows and fluctuations in underlying stocks and indices. That’s a derivative. What’s traded isn’t the asset but a proxy. A key reason why stock pickers struggle is because long-term investments are inconvenient, and the many parties in the market chasing one-day moves or short-term divergences drown out fundamental differences in businesses.

There’s a triune reason for volatility that’s getting bigger, not smaller.  First, the whale in the market is money tracking benchmarks like the S&P 500. Clustered next around the benchmarks are options and futures and ETFs. The ETF SPY yesterday traded nearly ten times the dollar-amount ($26.3 billion) of the nearest active stock (VRX, $2.7 billion). And last, every ETF has what’s in effect counterparties –authorized participants maintaining coherence between ETFs and indexes (to us it’s sanctioned arbitrage since the APs know which direction money is moving and can go long or short advantageously, which is ethically questionable). So also do counterparties back the options, futures and swaps fueling leveraged ETFs and trading schemes and index-tracking by big funds.

Line these up.  Money is tracking indexes. Leveraged ETFs are trying to beat them. Counterparties are supplying options and futures to achieve those returns. Every day it changes and the movements are like a freight train on a twisting track, picking up speed, as each gets a day or two out of step with the others.

At what point does it rupture? Making homes too easy to buy through loose credit led to mushrooming mortgage-backed derivatives and later mass demise. Making money too easy for governments to get through central banks is behind the creaking mountain of global debt that the private sector long ago largely stopped buying (so it’s instead held by central banks that pledged the full faith and credit of the same citizens refusing to buy in private markets).

We’d benefit from old-fashioned inconvenience. Investments taking more than a day to produce a return. What’s valuable – time, money, risk, production, thrift, prudence, diligence – shouldn’t be marginalized into a derivatives trade.  Alas, we humans seem to recognize mistakes only in hindsight.

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