Introduction
When I became a professional securities
analyst in the 1960s there was a trend to have two separate research and
marketing efforts of brokerage firms. A traditional effort to serve individual
investors was joined by a second, and
higher paid effort to serve institutional investors. Around the cyclical
movements of the stock market, individuals and institutions invested differently
and each fed off the other's transactions. Institutions were able to buy what
they thought were cheap stocks from supposedly unsophisticated individual owners
and sell into them when individuals were not well enough informed. Interesting
this dichotomy did not work to the disadvantage of the individual investors as
much as it may have seemed. Individual investors were not only net buyers, but
for the most part long-term investors that often facilitated the more rapid
turnover of the so-called professional investors.
This relationship is no longer the case.
Because of the decision of the US government to introduce price competition in
brokerage commissions (which led to a price war) the profitability of directly serving
the individual long-term investor declined meaningfully. Today try to get a
“full service” retail brokerage representative to be interested in opening an
account to handle the sporadic purchase of a hundred shares of a NYSE traded
securities. If the broker can’t get the customer to open a margin account, buy
new issues, trade over-the -counter securities or place decision making judgment
in a managed account or a packaged product or possibly an automated
relationship with a call center, chances are he/she will not be interested in
the relationship with the perspective customer. Only the alternatives just
suggested are profitable for the firm and the individual broker. Thus
relatively few individuals are directly active in today’s stock market. They
are investors through their employers’ defined contribution plans, land stock
purchase plans, and or mutual funds/variable annuities or in some cases stock
options.
The plain truth on most days, particularly
in the summer months, almost all the transactions come through various
institutional channels. The market has become largely a game of professionals
competing against each other for research and trades. In some respects the
market has become more susceptible to sudden volatility within the trading day
as the professionals in this interconnected world react to each incremental
research element and price change. Thus, a different sort of market analysis is
required to avoid being at a competitive disadvantage.
The Players
Exchange-Traded Funds (ETFs), and Exchange
Traded Notes (ETNs), while relative small in terms of assets as compared with
other institutions, are selectively
quite large in the intra-day markets. While the regulators believed that when
they permitted the creation of these vehicles in the US and a number of other
markets, that individual investors would benefit from their low cost and
trading efficiency, they really created trading vehicles for fast trading
professional investors including hedge funds, market makers, managed accounts
of investment advisors, central banks (Tokyo), and other institutional players.
In many weeks the aggregate net
transactions in ETFs is larger than those of conventional mutual funds, even
though their assets are less than half of the assets of mutual funds. While
there are thousands of ETF transactions in a given week, the vast majority of
transactions are in a couple of products that professionals are using to invest
or hedge with or without margin type leverage. According to my old firm,
Lipper, Inc., for the week ending
Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion
went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks,
and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of
that fund’s total net assets. This left approximately $100 million for net
purchases of all other equity ETFs.
A similar pattern was present on the
taxable fixed income side which had total net purchases in the week of
$1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total
U.S. Bond Market ETF.
All four of these funds could be used to
fulfill the short-term trading needs of institutions. To get a feel as to how
important the trading is in these products, one should look at the extreme
volatility of the major stock and bond indices in the last ten minutes of a
trading day as the Authorized Participants (APs) try to even up their trading
books. On some days in the last few minutes the stock indices can move close to
1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of
the transactions in ETFs are on the short side. In October of 2016 the size of
the short interest was at a record level on the SPDR S&P500 ETF. Currently
it is at the lowest level in more than a year. Obviously some trading
institutions were shorting due to their views on the US Election. They may have
viewed this as a hedge against some long positions or it could have not been
paired against other holdings.
Mutual Funds are Evolving
There is also something happening in conventional mutual fund transactions. Despite a current period of relatively
good fund performance, funds are experiencing net redemptions. A careful
analysis will reveal that this is not a signal of disappointment. Most of the
redemptions are coming out of the Large Cap Growth and Growth and Income funds
that were the major receivers of decades of inflows driven by commissioned
sales people. The basic investment pitch to potential owners of funds was to
provide retirement capital and to a lesser degree educational funding. On an
actuarial basis a good bit of these redemptions are completions fulfilling
their intended purposes. In prior decades we would not have seen net
redemptions because the normal completions would have been offset by new sales
of funds, except selling funds to individuals is far less profitable than it
has been in part because the sale freezes the money in place for a number of
years due to anti-churning rules and commissions on funds are no longer the
highest level available to the salesperson.
There is another important trend that
takes mutual fund dollars out of the US marketplace. While domestic funds in
the week had net redemptions of $4.6 Billion, non- domestic funds had net sales
of $2.6 Billion. This is understandable on two levels. The Financial
Times data shows that there are eighteen national stock markets it
tracks. Eight had gains of between twenty and twenty-six percent and only one
of these (NASDAQ) was in the US. The IMF is forecasting only India and China
will have GDP gains of more than 5%.
Chart Readers
All three of the major US stock market
indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ
composite started last week with a price upward gap. Often price gaps get filled
before a major move occurs. In addition the NASDAQ composite daily price chart
shows a reversal pattern called a “Head & Shoulders” which might be
predicting a decline. As part of the market’s function to promote humility,
this index is now rising near its former peak. The technical market analysts at
Merrill Lynch stated that if the index breaks out on the upside it would be a
failed Head & Shoulder pattern that is quite bullish. As usual there is an “on
the other side” market research team at Charles Schwab that suggests that we
should be prepared for a summer pull back.
Investment Conclusions
One of the reasons I came up with the
TIMESPAN Lipper Portfolios® is to address this
kind of situation, The second of the two portfolios, the Replenishment Portfolio,
has a function of replenishing the Operating Portfolio which is designed to
meet payment needs near term, or about two years. The Replenishment Portfolio expects
that over a market cycle it will be called to replenish the operating funds.
This assumes that over a cycle (which typically takes four to seven years)
there will be at least one down market. With this in mind Replenishment Portfolios
should be examining their liquidity positions . This will be easier if they are
in open end mutual funds that are not expected to “gate” or temporarily
restrict redemptions in cash. In some cases large redemptions will be met with
in-kind transfers. In most cases the transferred securities will be relatively
easily sold.
The other two portfolios, Endowment and
Legacy should not be disturbed. However if there was a serious decline one
might want to switch. My data and consulting client, the late and great Sir John
Templeton instructed to switch into better bargains when available.
__________
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A. Michael Lipper, CFA
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