This is the third in a short series of posts which addresses four important and inter-related problems with Wealth Management and by extension Asset Management and in conclusion offers a Solution.
The Problem for Stock Pickers/Active Equities is that in the short to medium term an increasing amount of stock price behaviour is a function of subscriptions and redemptions to the smart Beta baskets they are now a part of.
As we discussed in the previous two posts (The real problem with Bonds and The problem with Passive Equities) historic attempts to solve the inherent problems of low yielding bonds and the concentration risk of market capitalisation based indices have in turn created other problems, not least because of the definitions assumed around ‘risk’. The tendency to (largely) limit discussions of risk to what can be easily measured in terms of volatility and correlation with an index has not only led to a degree of ‘teaching to the test’ but also an omission of risk management around issues such as concentration, liquidity, leverage and (in the case of high yield bonds) balance sheet risk.
To some extent the correct response to this has been to acknowledge the role of active stock picking managers in the portfolios of Wealth Management clients, but here too we face an issue, which ironically arises from the market response to the previously noted ‘problem with Passive Equities’, the growth of Smart Beta baskets and ETFs.
The response to the Mega Cap concentration risk that emerged during the dotcom era was to create a whole new set of indices and ‘Smart Beta’ benchmarks to address the issue with passive investment that the index does not represent a sensible portfolio. It may technically (as a comment on a previous post noted) represent the ‘efficient portfolio’, but from a Wealth Management perspective, it is a long way from an effective one. Advances in technology have enabled the growth of relatively cheap funds to track these new indices, principally in the form of Exchange Traded Funds, or ETFs, which are effectively like Mutual Funds but can be bought and sold like any other stock.
There are in fact now more ETFs than there are underlying Equities, not surprising really, given the mathematics of factorials where even 4 variables can be arranged in 24 different ways. The majority of these ETFs are passive instruments that track some form of index or benchmark. As the chart from Bloomberg Intelligence shows, this crossover actually took place almost 5 years ago.
Partly, as noted, this is down to the emergence of Smart Beta and partly it is also down to a drive to lower costs, greater scale and higher profitability for the Investment management Industry. Most importantly however, we believe it is the emergence of Thematic Investing and the associated Indices/Benchmarks over the last five years that is delivering the problems now being faced by Stock Pickers, which is that, in the short to medium term, the ‘bots driving the new index ETFs are becoming the key driver of the price for many if not most of the component stocks and the more specialised and thematic the indices become, the more important subscriptions and redemptions become for mid-cap stocks.
The emergence of Thematic ETFs helps better portfolio construction, but creates distortions and liquidity problems for stockpickers
Stock movements now reflect the indices and benchmarks they are in more than anything else.
The new problem for Stock-picking therefore is that the giant, quasi passive, fund managers such as BlackRock and Vanguard are now the largest ‘owners’ of the overwhelming majority of individual stocks across multiple ETF strategies and the decisions to buy or sell have almost nothing any longer to do with stock fundamentals. Instead they have accelerated the impact of factors such as momentum and liquidity; inflows into a particular ETF strategy that has, say, a 3% weighting in a mid cap Tech stock will automatically create demand for that stock, regardless of its fundamentals and, if, as is often the case, that stock has a limited free float and a lack of daily liquidity, then the stock can squeeze sharply higher. This in turn can make the ‘mark to market’ on the ETF look highly attractive, pulling in new investors and exaggerating the situation still further. Markets of course are wise to this and numerous strategies have emerged around trying to ‘front run’ some of the biggest Thematic strategies by tracking their subscriptions and redemptions. Undoubtedly some of the sell off in mid cap Tech stocks in q4 was driven by outflows from giant thematic ETFs like ARKK, just as their equal and opposite ‘upward crash’ in q2 and q3 was driven by inflows.
Illiquidity means fragility
This is not confined just to Active ETFs like ARKK, but in many cases is even more relevant for the passive Thematic indices such as those run by quant giants like Vanguard and Blackrock, where there is effectively no discretion and ‘bots front-run the ‘bots. Famously there was situation where (with great irony) a Robotics themed ETF was being run by a ‘bot which kept trying to buy the stock of a Robotics company called Kuka that had just been taken over by the Chinese but where a tiny rump still existed. No-one had programmed the ‘bot with the new information and the illiquid rump squeezed dramatically higher until someone finally spotted it. This was an extreme example, but there have been multiple other issues with small and mid cap stocks being dominated by index ‘bots, something we discussed earlier this year, with particular reference to one of the ‘hot’ Themes from 2020, Clean energy.
As we noted at the time, the I-Shares Clean Energy ETF that we track as part of our Thematic Basket has a tremendous 2020, but one of the risks it was displaying in early 2021 was a concentrated exposure of around 8% in a single, illiquid stock, a ‘Hydrogen Solutions’ provider called Plug Power, largely in response to a massive January squeeze in the stock. The ‘bot kept buying as cash flowed into the ETF, regardless of any fundamantals beyond its market cap. In effect, everything has become a momentum strategy by default. The fact that the stock subsequently fell by more than 70% is a classic illustration of the circularity of this (accidental) momentum in-flow/outflow model. The inflow into the Index/ETF after a strong 2020 pulled the illiquid stock up drastically, leading to great short-term returns for both stock and fund and thus encouraging by turn more inflows into the Index/ETF and hence the stock. However, this was extremely ‘fragile’ and as the fundamentals turned and/or outflows started from the ETF (often associated with profit taking and tax years), the virtuous circle turned vicious. As an update, Plug Power is still around 5% of the ETF, largely reflecting a 60% drop in its market cap from the peak. Instead Solar Company Enphase now holds the title of the largest stock in the Index (8.5%). It appears to have had a similar positive experience to Plug Power, doubling from 140 to 280 in September and October as the ‘bots started buying (in turn helping the EFT), before coming off again to around 190. As a provider of microinverters it is exposed to Solar rather than hydrogen and like most in this area, is trading on around 20x revenues. It too is relatively small (c$25bn) with only 1-2% of float traded daily and as such has done little to improve/reduce the fragility of the ETF.
The problem now for stock-pickers is that, at least on a quarterly basis, the performance of many of their stocks will likely have more to do with the subscription and redemption cycle of various index tracking ETFs than their own fundamentals, making it hard to assess what is actually ‘in the price’ at any given moment. For managers where their own investors will tolerate volatility this is an opportunity to exploit, but for many who are monitored quarterly or even monthly it means even fewer active ‘owners’.
While Thematic ETFs have caused problems for Stock-Pickers, we actually see them as part of the long term solution to the wider problem of creating efficient portfolios for long term investors. However, because in our view single themes are not sufficiently diversified, not only in terms of industry but also in terms of the subscription/redemption impact on index behaviour, we need to view them in turn from a portfolio of themes perspective. Something we shall address in a subsequent post.
