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27-06-2015, 09:09 AM
CHANTICLEER Jun 26 2015 at 5:25 PM Updated Jun 26 2015 at 8:23 PM
Ashok Jacob warns about the robots behind Exchange Traded Funds
Ashok Jacob ... ETFs are "the most complex beasts in equity history". Sahlan Hayes
by Tony Boyd
Ashok Jacob, the chief investment officer at high performing fund manager Ellerston Capital, is not a fear monger but he is worried about the robots sitting behind booming Exchange Traded Funds.
ETFs are, according to Jacob, "the most complex beasts in equity history". He believes that one day they will be involved in a major financial market "accident".
Jacob's concerns, which were first expressed in a speech to the Annual Stockbrokers Conference last month, come at an interesting time in the development of ETFs.
They are clearly the most successful financial product launched in the past decade and pose an enormous threat to active fund management companies such as Ellerston Capital.
In Australia, ETFs have grown at a compound annual growth rate of 32 per cent over the past 10 years. There are now about 130 ETFs available in Australia with $18.6 billion in assets under management, according to ETF provider BetaShares.
Australian retail investors are embracing ETFs because of the low fees and general disenchantment with the failure of more expensive, actively managed funds to beat their benchmarks.
ETFs are a global success story. Since 2005, ETFs have grown from $US426 billion in assets under management to $US2.78 trillion or about 6.5 per cent of the total institutional investor universe of $US43 trillion.
Jacob comes to discussion about ETFs with considerable respect and market credibility. The latest 12-month performance numbers for all eight Ellerston funds beat their benchmarks.
"Superior investment performance comes from picking markets or sectors or geographies," Jacob says.
"Just as asset owners look to disintermediate the supply chain through low cost tracking funds, asset consultants encourage this disintermediation by attempting to generate alpha through a macro-economic or thematic approach.
"There is nothing wrong with any of this and the trend is a simple evolution of the financial services factory. But, money flows through ETFs in and out of underlying stocks completely independently of the movements in the investment fundamentals of any specific stock.
"As an example, the recent meteoric rise in Chinese shares has seen many red faces in the ETF industry. Some of the larger ETFs have only captured 70 per cent of the large but lightening gains.
"Similarly, a large Australian mining services contractor soared 60 per cent in a week but yet completed a round trip back down a week later. The apparent cause was a large New York ETF specialising in high yield equities which received a large inflow of funds.
"ETFs once created, are robotic and cannot be reprogrammed easily. The robotic approach is what the investor is buying.
"Thus, we see a parallel and different investment process moving trillions of dollars on an annual basis like a refinery with multiple pipes mixing different grades of fuel.
"Will there be accidents, perhaps major accidents along the way? Yes!
"But that does not mean the concept is not sound. Eventually, like in any automated factory process, they will be improved till they run faultlessly.
"The flaws that need to be ironed out are around rebalancing the underlying portfolios, whether daily or weekly, at the open or the close or at volume weighted average.
"It's like a blood transfusion or its reverse into a single living organism. It takes time for the organism to adjust to the new level of activity. That's called volatility and explains to an extent the extraordinary reactions to minor upgrades and downgrades by individual stocks. The robots are programmed to react."
Jacob's concerns about ETFs and their capacity to contribute to volatility in equity markets were echoed this week in the first business and finance outlook published by the Paris-based Organisation for Economic Co-operation and Development (OECD).
The report warns of the potential for problems when investing in ETFs with illiquid underlying assets.
"Products that offer daily liquidity while referencing illiquid underlying securities may face severe problems were there to be a run of redemptions on this asset class," the OECD warned.
In an interview with The Australian Financial Review, Adrian Blundell-Wignall, a special adviser to the OECD secretary-general and a former Reserve Bank of Australia official, said the huge expansion in pension investments in alternatives was causing a bubble in some asset classes.
"There's a big bubble in private equity, absolute return funds, hedge funds," Blundell-Wignall said.
The criticism of ETFs is dismissed by Ilan Israelstam, head of strategy at ETF provider BetaShares.
"It is simply plain wrong to describe ETFs as complex," he says.
"At their essence, ETFs are simply managed funds which trade on stock exchanges, and are oft praised for their simplicity and transparency. Unlike actively managed funds, investors in ETFs can, at any time, determine precisely what is inside the investment portfolio.
"The same can certainly not be said for actively managed funds."
Israelstam says the comment that really stood out to him from the OECD report was the following: "One strategy since well before the crisis has been for asset owners to move towards passive (index) funds in their long-only holdings (and away from higher-fee funds that promise but for the most part don't deliver 'alpha' versus a benchmarks)".
He says it is noteworthy that many active managers are now using ETFs in a tactical way to generate alpha, which is performance better than the market.
"ETFs deliver to investors exactly what they promise. As a matter of principle, we believe its nonsensical to blame ETFs in general for doing what they are supposed to do, which is to provide investors with a vehicle to express a view on the ETF's underlying assets."
It is true that any investment vehicle that invests in illiquid underlying assets will have problems when there is a run of redemptions. That happened with mortgage trusts in Australia following the crisis.
Israelstam says that none of the 129 ETFs in Australia provide exposure to particularly illiquid underlying assets.
"In Australia, there are a very small number of synthetic ETFs, all of which have been created where it is not possible to physically hold the underlying (e.g. oil, agricultural commodities)," he says.
"These products, however, suffer from no liquidity concerns as they are actually backed by cash (and provide exposure to highly liquid futures contracts)."
Tony Boyd
Twitter: @TonyBoydAFR
tony.boyd@afr.com.au
Ashok Jacob warns about the robots behind Exchange Traded Funds
Ashok Jacob ... ETFs are "the most complex beasts in equity history". Sahlan Hayes
by Tony Boyd
Ashok Jacob, the chief investment officer at high performing fund manager Ellerston Capital, is not a fear monger but he is worried about the robots sitting behind booming Exchange Traded Funds.
ETFs are, according to Jacob, "the most complex beasts in equity history". He believes that one day they will be involved in a major financial market "accident".
Jacob's concerns, which were first expressed in a speech to the Annual Stockbrokers Conference last month, come at an interesting time in the development of ETFs.
They are clearly the most successful financial product launched in the past decade and pose an enormous threat to active fund management companies such as Ellerston Capital.
In Australia, ETFs have grown at a compound annual growth rate of 32 per cent over the past 10 years. There are now about 130 ETFs available in Australia with $18.6 billion in assets under management, according to ETF provider BetaShares.
Australian retail investors are embracing ETFs because of the low fees and general disenchantment with the failure of more expensive, actively managed funds to beat their benchmarks.
ETFs are a global success story. Since 2005, ETFs have grown from $US426 billion in assets under management to $US2.78 trillion or about 6.5 per cent of the total institutional investor universe of $US43 trillion.
Jacob comes to discussion about ETFs with considerable respect and market credibility. The latest 12-month performance numbers for all eight Ellerston funds beat their benchmarks.
"Superior investment performance comes from picking markets or sectors or geographies," Jacob says.
"Just as asset owners look to disintermediate the supply chain through low cost tracking funds, asset consultants encourage this disintermediation by attempting to generate alpha through a macro-economic or thematic approach.
"There is nothing wrong with any of this and the trend is a simple evolution of the financial services factory. But, money flows through ETFs in and out of underlying stocks completely independently of the movements in the investment fundamentals of any specific stock.
"As an example, the recent meteoric rise in Chinese shares has seen many red faces in the ETF industry. Some of the larger ETFs have only captured 70 per cent of the large but lightening gains.
"Similarly, a large Australian mining services contractor soared 60 per cent in a week but yet completed a round trip back down a week later. The apparent cause was a large New York ETF specialising in high yield equities which received a large inflow of funds.
"ETFs once created, are robotic and cannot be reprogrammed easily. The robotic approach is what the investor is buying.
"Thus, we see a parallel and different investment process moving trillions of dollars on an annual basis like a refinery with multiple pipes mixing different grades of fuel.
"Will there be accidents, perhaps major accidents along the way? Yes!
"But that does not mean the concept is not sound. Eventually, like in any automated factory process, they will be improved till they run faultlessly.
"The flaws that need to be ironed out are around rebalancing the underlying portfolios, whether daily or weekly, at the open or the close or at volume weighted average.
"It's like a blood transfusion or its reverse into a single living organism. It takes time for the organism to adjust to the new level of activity. That's called volatility and explains to an extent the extraordinary reactions to minor upgrades and downgrades by individual stocks. The robots are programmed to react."
Jacob's concerns about ETFs and their capacity to contribute to volatility in equity markets were echoed this week in the first business and finance outlook published by the Paris-based Organisation for Economic Co-operation and Development (OECD).
The report warns of the potential for problems when investing in ETFs with illiquid underlying assets.
"Products that offer daily liquidity while referencing illiquid underlying securities may face severe problems were there to be a run of redemptions on this asset class," the OECD warned.
In an interview with The Australian Financial Review, Adrian Blundell-Wignall, a special adviser to the OECD secretary-general and a former Reserve Bank of Australia official, said the huge expansion in pension investments in alternatives was causing a bubble in some asset classes.
"There's a big bubble in private equity, absolute return funds, hedge funds," Blundell-Wignall said.
The criticism of ETFs is dismissed by Ilan Israelstam, head of strategy at ETF provider BetaShares.
"It is simply plain wrong to describe ETFs as complex," he says.
"At their essence, ETFs are simply managed funds which trade on stock exchanges, and are oft praised for their simplicity and transparency. Unlike actively managed funds, investors in ETFs can, at any time, determine precisely what is inside the investment portfolio.
"The same can certainly not be said for actively managed funds."
Israelstam says the comment that really stood out to him from the OECD report was the following: "One strategy since well before the crisis has been for asset owners to move towards passive (index) funds in their long-only holdings (and away from higher-fee funds that promise but for the most part don't deliver 'alpha' versus a benchmarks)".
He says it is noteworthy that many active managers are now using ETFs in a tactical way to generate alpha, which is performance better than the market.
"ETFs deliver to investors exactly what they promise. As a matter of principle, we believe its nonsensical to blame ETFs in general for doing what they are supposed to do, which is to provide investors with a vehicle to express a view on the ETF's underlying assets."
It is true that any investment vehicle that invests in illiquid underlying assets will have problems when there is a run of redemptions. That happened with mortgage trusts in Australia following the crisis.
Israelstam says that none of the 129 ETFs in Australia provide exposure to particularly illiquid underlying assets.
"In Australia, there are a very small number of synthetic ETFs, all of which have been created where it is not possible to physically hold the underlying (e.g. oil, agricultural commodities)," he says.
"These products, however, suffer from no liquidity concerns as they are actually backed by cash (and provide exposure to highly liquid futures contracts)."
Tony Boyd
Twitter: @TonyBoydAFR
tony.boyd@afr.com.au