Sunday, July 30, 2017

(1.) Future Investment Success Depends on Productivity, (2.) A Possible Re-play of Sub Prime Crisis


Often a publicized trend enters into private conversations. During the summer two day meeting of the Board of Trustees of the California Institute of Technology, there is a dinner with selected undergraduate, graduate, and post docs with some of their professors. At the dinner last week, we were sitting at a table with other trustees, some of the students and a very prominent young professor. She turned to the trustees present and asked. “What should Caltech focus on in the future?”

The initial reply was from a trustee who has earned all three of his degrees from Caltech. His answer was that Caltech should continue to seek to hire the very best professors which would attract the very best students. I applaud this continuing goal set, and I suggested that for the future there should be an additional goal. This goal should be to increase the productivity of the professors, students, and staff, and therefore society.

As a board member and contributor to a number of other non-profits, I am seeing this need in lots of places throughout our global society. I suspect that future structural improvements in productivity will be led by a combination of commercial interests and a few non-profit leaders.

Economic and Business Trends

One of the best commentators on these trends is my Securities Analyst Society friend, Byron Wien. In his latest publication for Blackstone he laments that one of the biggest risks is “the inadequate investors’ attention to productivity.” He points out that productivity has been declining since it peaked globally in the 1996-2005 period, except in China and India (increasing areas of investment interest in the funds in our clients’ portfolios). He further points out that the number of new companies has declined by 50% and the number is about equal to the numbers of companies that disappear. (Many of those that disappear are doing it voluntarily through the richness of M&A activity, lack of family interest to continue to work hard as the founders, and tax considerations.) He  suggests that since the development of the internet and smart phones there have not been significant productivity inducers. He laments the decline in high school students mathematical capabilities.

On this topic, I applaud the generous gift by Ronald and Maxine Linde that re-purposed the Caltech mathematics  building into the Ronald and Maxine Linde Laboratory of Mathematics and Physics.

To focus on the significance of the productivity problem, I wonder whether more attention should be given to a statistic I used as an analyst which was the ratio of revenue and costs per employee. In both the profit and non-profit arenas the additional costs of compliance and welfare oriented employees may be causing these ratios to narrow and thus the number of employees, I did not say workers, is a useful statistic.

Actually part of the productivity problem has more to do with personalities than pure analytical ratios. While profit margins are expanding due to higher returns from capital expenditures than employees, it is understandable these margins are hiding the very pedestrian growth in top line revenues adjusted for price increase. Too often sales are fulfilling only existing demand, not in problem-solving or creating new demand. In many companies and non-profit agencies clients are only to be tolerated, not cherished as the real assets of the activity.

Help is on the way. Currently the best performing fund in our clients’ portfolio has changed its name and focus to Innovators Fund Investment.

Perhaps the most bullish area that is benefitting from global attention is consumer spending and activity. In many of our homes and lives we still do things the way we did years ago. But today we can utilize the internet to search and buy items we did not have. We are already benefitting from the delivery of medical services through electronic communication. The race is on to remotely automate elements within our home for higher functionality than what we had in the past. The question is how we are going to use the time efficiency in our personal rising productivity, which is not in the published productivity numbers?

There are some reasons to be positive long-term.

Are Sub-Prime Type Risks Lurking?

One of the key responsibilities of prudent analysts and portfolio managers is to worry, particularly when others don’t. Many of the worries about the future do not come to pass, but some do. A full ten years has elapsed since the public recognition of the problems created by the excessive use of sub-prime residential mortgages. Are there similar type risks today? One should remember the old quote about history not fully repeating, but rhyming with the past. To me the keys to these concerns are not in the instruments but in the behaviors that are similar from one era to others. In an over-simplification, a list of some behaviors shown below could be useful in identifying future problems:

1.  Reliance on the predictability of long-term trends
2.  Investment vehicles that can be leveraged
3.  Inexperienced investors and advisors
4.  New entrants, some from well-known organizations facing slow downs
5.  Media cheerleaders
6.  Few skeptics
7.  Things not what they seem
8.  The deep linkage with the larger financial community
9.  Lack of specific regulatory oversight
10. Global activity

Some may feel the current wave of enthusiasm for Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) apparently has some of the similar characteristics experienced in the sub-prime era. The results don’t have to turn out the same way, but prudent investors should consider the parallels and make their own judgments.

The underlying statistical trend that made mortgages attractive was that housing prices always went up, though the careful student of long-term history could point out some long periods when this was not the case. The possible equivalent today is that active managers on average can’t beat the popular market averages, but it is happening in 2017.

It is cheaper to use ETFs and ETNs to leverage market bets than the purchase of futures contracts. Thus traders of all types including hedge funds are rapidly moving in and out of these products either to express a short-term market view or as part of a hedging operation on the long or short side.

Utilizing information that was called to my attention by Lilia and Leo Clemente, illustrates the rapidity of these flows in a particular week’s net flows as a percent of the aggregate assets in a specific fund.

Exchange Traded Funds are a fast changing market as they evolve into increasingly a trading market.  One measure of the manic weekly inflows is to measure the net weekly flow for a specific fund, as a percent of the asset under management in the fund. 
Net Flows
AUM % Change
Goldman Sachs Treasury Access 0-1 Year
83.07 %
iShares MSCI Japan Small Cap
13.35 %
Kramer Shares CSI China Internet
8.80 %
SPDR Bloomberg Barclays High Yield Bond
8.68 %
iShares Short Treasury Bond
7.89 %

These weekly net flows are in USD millions and we don't know the size of the gross numbers, but clearly the aggregate size of the trading would represent a larger share of the assets under management.

I suspect most of these transactions were by trading activities, including fee paid discretionary investment advisors.

The size and volatility suggests to me that there are speculative forces at work. 

I am seeing many traditional active mutual fund and brokerage shops entering the ETF and ETN markets. In terms of details and the personalities in the market place, they are quite different than the market participants that were successful in the past. Since many of the ETF and ETN manufacturers advertise heavily, there are few media skeptics.

Many of the users of these products have not taken the time and the continuing effort to understand the construction of these portfolios and the mechanisms for change. Also some of these products have built-in, larger than normal fees.

Most of the transactions in these products are conducted through “authorized participants” (AP) these are largely dealers who utilize their undeclared capital for all of their trading activities. Goldman Sachs* has recently withdrawn from being an AP. Goldman is an intelligent prudent risk seeker. For them to withdraw could be indicative of either too high risk or too low profitability. Due to the linkage, largely through counterparts leverage, a problem in these markets can generate rumors of bigger financial community problems.
*Owned personally or by the private financial services fund I manage

These products do not have a specific regulator but are overseen by numerous securities and financial regulators some of whom are thinly staffed.

In many countries that have a viable, active, securities markets there are either locally manufactured or globally traded ETFs and ETNs with different degrees of intelligent regulation.

Just be careful .   
Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of

Copyright ©  2008 - 2017

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

No comments: