ETF's likely peaking -just when its most popular to invest in these.

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Past: A rising tide lifts all boats.  Now: The allure of low fee funds with no management is about to peak.

Morgan Stanley in an intelligent new February 2017 client research piece called “The case for Active Management” points this likely coming to and end in 2017.   Central Bank quantitative easing along with secular stagnation of economies provided a unique set of tailwinds -but these are now starting to dwindle.

For some years now, actually ever since the 2008 N.Atlantic induced financial crisis, passive investing has steadily showed outperforming managed alternatives. Passive ETF investing is, to simplify, just picking ETF or similar lowest cost funds which bring no management or stock selection  -and just invest in a stated stock index. Many studies, books and articles of recent and over the past couple of years have proudly pointed out that ETF investing beats the more expensive managed alternatives and insinuate –and how this is the “new normal”…and recently they have.  I.e. the trend has been: forget paying a fund manager or a hedge fund, instead just invest in stock index funds through ever more glamorous EFT’s.  In year 2016 for example, in the US, only 26% of active big cap stock managers outperformed the benchmark stock index and this extended what has been a subpar performance for a 5-year stretch.

Passive Investor Vehicles.  Remember a stock index fund like ETF's, just allocates its investor capital to an index without making any selection choices. Usually, the bigger the stock, the more they invest there. Call it dummy investing without any selection at all.  The issue is that such investing has risen to prominence of late and so now advocated by many now, as if it’s the new nirvana to investing and suggesting it will never change back.  “Save the fees and invest in ETF's” has become an investor mantra of late.

The drivers of what lead to such divergence should be understood.  First, over the past 9 years the US and most stock markets have zig-zagged up pretty much across the board due to 4 main big reasons:  1) ever lower global interest rates which just about always bullish for stocks,  2) along with absence of any real inflation,  3) absence of any new major world crisis,  4) coming off a major bottom to begin with, post the 2008 stock market horror back then. In addition, an unchanging shake-up in politics… more or less a "status quo".  Hence most money manager which control risk exposure and have cash on hand (as most do) played it more prudent with a first objective of capital preservation. These so failed to beat major stock index funds, as they just could not keep up with the always by definition fully invested ETF’s.  They just could not keep up with a steady rising market of below 8000 on the Dow Jones in 2008 to presently over 20,000 now.  Pretty obvious that anything short on being fully invested most probably meant lagging behind any major stock market index.

“Passive strategies have the highest probability of success when the largest companies have positive momentum, volatility is very low…and markets are liquidity driven”.  Morgan Stanley February 2017.

The bloated ETF industry of late has extrapolated this superior performance of late to their advantage -in full bloom.  Basically claiming “forget paying active stock managers, instead just invest in their lowest fee ETF funds -and be done with it”.

As Morgan Stanley (MS) points out and gives periods for such divergences. For example, from 1983 to 1988 and again 1995 to 2000 these have been similar periods in the past where for those 5 years fund managers underperformed;  only to then rise again and show their value again when stock markets became more lethargic or difficult -which then makes stock selection and active management far more important.  MS like me, believe we presently are entering this back to normal period.  Few US periods are or will be similar then the past 8-9 years where contrary to so many nay-sayers financial assets rocketed up.

MS firmly predict this year will see a shift back as the major drivers of the past have now exhausted their positives;  and so ETF success is peaking.  Changes are in the making like: low(est) interest rates and inflation, US$ strength, a US business cycle likely maturing, major and uncertain tax reform, political regime change and changes to trade policy are just some of the drivers.  Since the US election outcome as MS states both: “cross-asset class and stock pairwise correlations have plummeted”. Not sure what that means but they state this is the early evidence.  I much agree with their prognosis and have (early) warned about such a reversal likely in the making, for some time.  

After many years of ETF’s having their glory and so growing to oversized bloated levels, most ETF fans will be left behind and lag when this macro investor theme shifts and/or markets turn.  By the time these catch on, much of their previous investor wisdom on passing by smart money managers and investing directly will have been thinned away because they did not see (these) changes coming.  Called it the evolutionary truth, for all the reasons given above, where adapting to changes' now happening -more than endorsing the consensus present-  is a recognition most stale investors will miss.

Best Regards,

Paul A. Renaud.
www.thaistocks.com