“Bait and Switch”?
CNBC reprised the flawed Yale Op Ed, so the industry must endure another day of misused, poorly researched, essentially “fake” data to explain why they don’t route aggressive orders or post displayed orders to IEX (where they under-perform). The bottom line is that IEX is a good dark pool, and the industry knows it. Thus, they execute over 40% of their 605 reportable volume on midpoint to midpoint orders. Because of that, and IEXs meager displayed quotes, when IEX does receive marketable orders, they under-perform (EQ in AAPL of 127 vs less than 100 for large exchanges). All this was documented on this blog yesterday. A key point, however, is that CNBC’s viewers include a large number of retail investors, the vast majority of whom, can’t place the dark, pegged orders that IEX improved. Thus, their article (accidentally and unwittingly) promoted IEX in something akin to a “bait and switch” – The “bait” is that IEX’s execution quality is excellent on dark and midpoint order types, but the “switch” is that those order types are generally not available to retail, so retail investors will likely receive inferior execution quality to what is being reported. The best way for CNBC to fix this is to report on how IEX performs on both marketable and displayed orders separately from dark. Lucky for them, I have already written on this and will happily go on air to explain it, either individually, or in a debate format with representatives from IEX or the Yale professors…
ETF / passive investment coverage is confused
Reuters published an anti-ETF piece that conflates multiple factors in the Active vs Passive debate. It’s headline, which suggests that ETFs create excess risk in a market downturn, is absurd. While true that if investors, en masse, pull out of a market in a downturn, that downturn will accelerate, it is equally true of mutual fund investors, or actively managed separate account investors. The difference between active and passive funds is that passive funds can distort the relative valuation of assets; passive funds invest mechanically, and are, therefore, insensitive to the valuation of individual assets. This has effectively shifted the supply demand curves for index constituents higher than non-index members, which active managers need to consider when determining their price targets. If, however, there was a mass liquidation event, the supply/demand effect of passive trading would start to reverse, which could lead to steeper falls for the more over-valued assets.
The only “feature” of ETFs that could exacerbate a market fall intra-day is that it is cheaper to transact in ETFs than mutual funds, which, I suppose, could encourage slightly more selling in a downturn. That, however, is likely offset by the fact that ETF sellers can liquidate throughout the day, which would spread out the selling pressure, when compared to mutual funds which only provide proceeds at the closing NAV.
The article also calls into question the holdings of ETFs and questions whether there are enough underlying holdings for the AUM of the ETF itself. For the majority of these instruments, failure to hold 100% of the underlying instruments would constitute fraud, so the accusation is unlikely. That said, if there was no bid for the underlying assets in an ETF, the price could (and would) fall. If such funds hold a lot of overvalued assets, then there could be a substantial “shock” if the passive investors were the only marginal buyers of those stocks and that trend reversed. At least mutual funds have the ability (in theory) to resist paying “bubble” valuations for individual companies, but that did not seem to matter in 2000/2002 for internet stocks. Lastly, it is important to understand that ETF market makers often rely on hedge instruments such as futures to maintain their tight, two sided markets. Thus, as we saw on August 24, 2015, when the futures markets are halted, pricing in ETFs can become unreliable for a short period of time.
The most serious accusation in this article pertains to “exotic” ETFs that employ substantial leverage or use derivatives to back them. On this point, I concede that there could be an issue, but have no direct knowledge either way. As an aside, some ETNs, however, have experienced substantial divergences. Issues such as TVIX and DGAZ, at times have seen their price become disconnected from their true value (NAV) due to limited supply and an inability for market makers to borrow shares. That issue deserves further examination.
Active Passive Hybrids Anyone?
Also on the subject of the active vs passive debate, Bloomberg published a good article by Barry Ritholz that correctly identifies one misreported aspect of the debate; the fact that many indexes make active selection decisions. As an aside, the silver lining to this is that investment advisors can use sector or factor tracking ETFs to construct active asset allocation portfolios at a low cost, which is good news to investors. The article, however, goes a bit “off the rails”, when he says that active portfolios should be 100% active and passive portfolios should be 100% passive. A more optimal approach would be active/passive hybrid portfolios as I described in my Captain Kirk article. Portfolio managers adept at picking out-performers and under-performers can (and should) construct passive portfolios (at low cost) to match the benchmark, and then overweight or underweight those stocks where they have conviction in their predictions. Such managers can charge hefty fees for those decisions, but the blended cost (of managing the active and passive positions together) would be lower than today’s active managers. This approach is both lower risk and more likely to outperform separate portfolios, as it would require less trading overall and add the incremental out-performance of accurate under-perform predictions without having to allow short sales.
Active Managers lowering costs to combat passive competition, but are they improving their process?
Bloomberg reports that UK based manager Baillie Gifford is taking some steps to reform active management. The article focuses exclusively on two points, cutting costs and providing performance net of fees, however, and does not speak to the investment process. If they are cutting fees by running active portfolios alongside passive, by implementing the hybrid strategy I recommended, good for them. If, however, they continue to have their portfolio managers operate independently of portfolio risk optimization and trading, then despite being “better” than 87% of their peer group, they are still likely far short of optimal. The point is that active management, in most cases, is about out-performance of a stock benchmark, not absolute returns. This type of manager should not be engaged in either market timing (unless that is a demonstrated and disclosed competence) or taking “bets” against index constituents when they have no opinion on the value of those instruments. Unfortunately, without incorporating passive trading techniques and quantitative technologies, active managers often do both, sometimes unwittingly….