Is there a way to create mutated ETFs that doesn't destroy capitalism?

A. What is an ETF, from the inside?

1. An Exchange Traded Fund is a mutual fund whose Units are tradable in a stock exchange. It consists of a pre-determined and unchanging set of stocks/bonds/options or a combination thereof, and investors simply collectively hold it through a manager. The investors might (but usually doesn't) have the right to ask the managers to sell the underlying portfolio in the open market and give their money back. They usually sell their Units to somebody else, in case they want liquidity, without affecting the manager or touching the collective portfolio. Either way, it is imperative that the underlying securities that constitute the collective portfolio must be listed and extremely liquid (otherwise buying/selling the collective portfolio will significantly move the prices in the former case, and transparent pricing of the ETF units themselves cannot be done in the latter).
2. But how much of the real Indian GDP/economy is represented by the listed and highly liquid segment of the stock market? One doesn’t have to be a financial expert to know that the vast majority of our country’s employed population, their consumption and investment, has nothing to do with the Nifty 50 stocks (and for that matter, around 95% of corporate debt of even large listed companies are not even actively traded) For reference, the cumulative earnings of all the listed companies in the Bombay Stock Exchange doesn’t even add up to 1% of India’s GDP!

B. How did such simple securities become the dominant industry-leader?

1. IT'S CHEAP

ETFs typically have lower management fees compared to their actively managed counterparts, with expense ratios ranging from as low as 0.05% to around 0.5 % (depending on the fund's strategy, provider, lock-in horizon etc.) In contrast, the expense ratios for actively managed mutual funds often fall within a broader range of approximately 0.5% to 2%, or even higher for some specialized funds (notwithstanding profit-sharing models AIFs and PMS and hedge funds often use). This significant cost difference underscores one of the key advantages of ETFs, making them an appealing option for investors seeking to minimize expenses while gaining exposure to diversified (and therefore less prone to non-systemic risk) portfolios.

1. MARKETS ARE EFFICIENT

As per greats like Burton Malkiel, Eugene Fama and others, the Efficient-Markets Hypothesis (EMH) posits that asset prices reflect all relevant information, making it impossible to consistently outperform the market. Attempts to beat the market through stock selection or timing are futile. Additionally, stock prices follow a random walk, rendering future movements unpredictable and challenging the effectiveness of technical analysis or historical data-based predictions (there are varying degrees of this hypothesis that scholars often disagree upon, namely strong, semi-strong and weak, but the underlying principle is the same). Therefore, any extra energy spent on picking stocks/bonds etc. is time (and therefore money) wasted.

An important hidden assumption here is that participants can actually trade on the information, i.e. long/short something within the infrastructure of the market itself, for this to be true. Remember this as we are going to use this in our later Blog.

1. COMPOUNDING EFFECT OF WASTAGE

The wastage of that extra-fees adds up over long-periods of time, and the ETFs outperform actively managed funds after accounting for costs and volatility. To put it into perspective, the SPIVA U.S. Scorecard for year-end 2020 reported that over the 15-year period ending 31st Dec 20, more than 88% of active large-cap funds, 92% of mid-caps, and 94% of small-caps under-performed their benchmark indexes, and the SPIVA Global Scorecard indicated that over the 10-year period ending 2020, more than 83% of global equity funds, 89% of international equity funds, and 93% of emerging markets equity funds under-performed theirs. With some adjustments for market-conditions, category and a few exceptional active managers, it is common to see median underperformance figures ranging from 0.5% to 1.5% p.a. across various market segments, which implies a difference between Net Asset Values (NAV) of more than 25% (between Active Funds and their corresponding ETFs) over a period of 15 years!

C. How does the ETF look from the outside?

That is, how does an ETF behave from the perspective of the Unitholder, ignoring for argument's sake what it is made of inside? Exchange Traded Funds track a pre-decided index of stocks/bonds/options etc. (within a small margin of tracking-error). The reason it is so useful is because of the three following reasons;

1. The indices are publicly accessible, so that both the Unitholders and the fund managers must agree on what its value is (in terms of the local currency) at all points of time.
2. The indices are well-diversified within a particular category, e.g. a large-cap index like S&P500 consists of a weighted selection of the 500 biggest listed firms in the US, Nifty Midcap 100 consists of the 100 most liquid midcap stocks in India and so on. In effect, from the investor’s perspective, buying portions of such an index gives them exposure to the overall movements of that market-segment without exposing them to the vagaries of the individual constituents themselves (like competitive pressures, pedigree of management, accounting frauds etc.).
3. Control of the index is not in the hands of the fund managers i.e., third-party institutions or agencies like Dow Jones, S&P, Morgan Stanley, NSE, CRISIL etc. construct these indices based on well-thought out and publicly declared parameters, and even changes in them (a rare thing) like weights of individual components, happen after announcing them beforehand.

In our next Blog explaining our innovation that (in principle) solves the problem with ETFs, we will use the above to show how other real economic indicators (e.g. bank interest rates, house prices, wages etc.) can be used to the same effect. Essentially, our financial products ‘looks like ETFs from the outside’ but are constructed very differently inside!

D. Why does Active Management fail and ETFs succeed?

1. FEES FOR ‘EXPERTISE’

There is an additional cost to hiring an expert to pick the constituents of the collective portfolio and change them from time-to-time (even assuming zero frictional and trading costs). That by itself is not a problem. The issue arises after global investors realized that the value they are getting back from their so-called expertise, in terms of extra-returns on their respective benchmarks, is not worth it at all (especially over the long-term).

1. RESPONSIBILITY DOESN'T LIE WITH POWER.

Active Mutual Funds, REITs and InvITs have no skin in the game i.e. clients pay a fixed management fee (in percent of AUM terms) whether the portfolio underperforms the benchmarks or not. Hedge Funds have an element of profit-sharing (e.g. 20% of profits paid to the fund manager for outperforming a preset benchmark) so it's a better fee-structure than ordinary mutual funds. But on the other hand a 20% loss for underperforming benchmarks are NOT shared, so even for them it is one-sided! Consequently, there is no real incentive for a manager to generate alpha. It's no surprise therefore that the AMC prioritizes marketing over strategy. Furthermore, the possibility of front-running (both on their asset and liability side), enriching the manager over the Unitholders, remains open as a result.

E. ETFs distort markets and can eventually destroy capitalism.

1. EVERYBODY EXPECTS SOMEBODY ELSE TO KNOW BETTER

Bloomberg has a bunch of nice articles on Passive Investing. Several big hedge fund managers like David Einhorn are claiming ETFs are destroying capitalism. The core idea is that ETFs simply pick a basket of securities randomly from a set of available options. But that only works if a large proportion of the market participants are continuously doing research & analysis on the valuations (and trying to predict the cost-of-capital volatility earnings potential etc.) of all the securities that form the market. In turn that leads to efficient price-discovery and their prices strongly-connected to its fundamentals. Understandably, that can only happen if the participants (at the margins), going long/short on a security (to manifest their opinion of market mispricing) are being compensated sufficiently for being right. But how can it work if the other investors are not even interested in discovering the price? Even a good long/short bet (based on solid research) will not be manifested in reality as the majority of investors do not affirm it eventually therefore prices won't move and those researchers will never make money! And if the markets are not rewarding good research, eventually efficient price discovery will die. Markets are essentially just a voting mechanism. If a majority doesn't care about whether a price is overvalued/undervalued, it will stay that way. ETFs by definition do not care, and the dominant majority of investors are ETFs at this point.

2. FEEDBACK LOOP FROM FUND-FLOWS, DISCONNECTED FROM FUNDAMENTALS

Additionally, there comes the problem of wrong incentives for firms to maximize shareholder value through inclusion in ETFs, and ETFs creating a positive feedback loop based on the amount of inflow into the basket from (new) Unitholders, as opposed to the performance of the underlying portfolio constituents themselves (i.e. their earnings growth rising/declining, volatility and cost of capital changing etc.). Already this has caused extreme concentration of wealth (P/E multiples) for the stocks of already gigantic firms, and away from a large number of smaller ones (who cumulatively make up a much larger portion of the real economy/GDP and employment). Due to the ETF structure, large weightage (in terms of market capitalization) draws an even larger proportion of the incoming investor funds, thereby increasing market capitalization further (compared to stocks not forming part of ETFs), reinforcing this cycle. The trouble is that when the fund-flow process works in reverse from ETFs, it will lead to an equally swift destruction of wealth for investors of these gigacap firms, leading to forced-selling (due to leverage) and further price-crashes, magnifying the economic crisis irrespective of the underlying health of the firms themselves.

F. So is Capitalism Doomed?

Several industry veterans and some of the smartest people in the world have been working on this problem for quite some time. But maybe traditional thinking won't get us there. A fresh perspective might. And we exist to disrupt. We are a Company that solves problems, not just points them out.

Our team has created an innovative solution, and it is 'out of the box' in the true spirit of the word. We will explain the structure of our financial product, and how in principle it retains the virtues of ETFs while also preserving capital markets. in our next Blog.