October 21, 2015

Turnover

Earnings season.

Late nights for IR professionals crafting corporate messages for press releases and call scripts. Early mornings on CNBC’s Squawk Box, the company CEO explaining what the beat or miss means.

One thing still goes lacking in the equation forming market expectations for 21st century stocks: How money behaves. Yesterday for instance the health care sector was down nearly 2%. Some members were off 10%. It must be poor earnings, right?

FactSet in its most recent Earnings Insight with 10% of the S&P out (that’ll jump this week) says 100% of the health care sector is above estimates. That makes no sense, you say. Buy the rumor, sell the news?

There are a lot of market aphorisms that don’t match facts.  One of our longtime clients, a tech member of the S&P 500, pre-announced Oct 15 and shares are down 20%.  “The moral of the story,” lamented the IR officer, an expert on market structure (who still doesn’t always win the timing argument), “is you don’t report during options-expirations.”

She’s right, and she knew what would happen. The old rule is you do the same thing every time so investors see consistency. The new rule is know your audience. According to the Investment Company Institute (ICI), weighted turnover in institutional investments – frequency of selling – is about 42%.  Less than half of held assets move during the year.

That matches the objectives of investor-targeting, which is to attract money that buys and holds. It does.  In mutual funds, which still have the most money, turnover is near 29% according to the ICI.

So if you’re focused on long-term investors, why do you report results during options-expirations when everybody leveraging derivatives is resetting positions?  That’s like commencing a vital political speech as a freight train roars by.  Everybody would look around and wonder what the heck you said.

I found a 2011 Vanguard document that in the fine print on page one says turnover in its mutual funds averages 35% versus 1,800% in its ETFs.

Do you understand? ETFs churn assets 34 more times than your long-term holders. Since 1997 when there were just $7 billion of assets in ETFs, these instruments have grown 41% annually for 18 straight years!  Mutual funds?  Just 5% and in fact for ten straight years money has moved out of active funds to passive ones.  All the growth in mutual funds is in indexes – which don’t follow fundamentals.

Here’s another tidbit: 43% of all US investment assets are now controlled by five firms says the ICI. That’s up 34% since 2000.  The top 25 investment firms control 74% of assets. Uniformity reigns.

Back to healthcare. That sector has been the colossus for years. Our best-performing clients by the metrics we use were in health care. In late August the sector came apart.  Imagine years of accumulation in ETFs and indexes, active investments, and quantitative schemes. Now what will they do?

Run a graph comparing growth in derivatives trading – options, futures and options on futures in multiple asset classes – and overlay US equity trading. The graphs are inversed, with derivatives up 50% since 2009, equity trading down nearly 40%. Translation: What’s growing is derivatives, in step with ETFs. Are you seeing a pattern?

I traded notes with a variety of IR officers yesterday and more than one said the S&P 500 neared a technical inflection point.  They’re reporting what they hear. But who’s following technicals? Not active investors. We should question things more.

Indexes have a statutory responsibility to do what their prospectuses say. They’re not paid to take risk but to manage capital in comportment with a model. They’re not following technicals. ETFs? Unless they’re synthetic, leveraging derivatives, they track indexes, not technicals.

That means the principal followers of technical signals are intermediaries – the money arbitraging price-spreads between indexes, ETFs, individual stocks and sectors. And any asymmetry fostered by news.

Monday Oct 19 the new series of options and futures began trading marketwide. Today VIX measures offering volatility as an asset class expire.  Healthcare between the two collapsed. It’s not fundamental but tied to derivatives. A right to buy at a future price is only valuable if prices rise. Healthcare collapsed at Aug expirations. It folded at Sept expirations. It’s down again with Oct expirations. These investments depended on derivatives rendered worthless.

The point isn’t that so much money is temporary. Plenty buys your fundamentals. But it’s not trading you.  So stop giving traders an advantage by reporting results during options-expirations. You could as well write them a check!

When you play to derivatives timetables, you hurt your holders.  Don’t expect your execs to ask you. They don’t know.  It’s up to you, investor-relations professionals, to help management get it.

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