Small Investors and ETF Industry Trends

Several recent articles, such as this one from Seeking Alpha, note that individual retail investors appear to be benefiting from the trend of using ETFs in more portfolio applications. According to Seeking Alpha, assets in ETFs exceed the assets in hedge funds, which I thought was interesting. But then I thought back over my 40-plus years in the finance industry and realized that this makes perfect sense.

Hedge funds came into being because there were investment strategies and financial instruments that the small, individual investor could not access. Structured properly as a private fund (known today as hedge funds), these funds allowed sophisticated investors to pool their money and take advantage of these strategies and instruments. Some of these strategies include securities arbitrage, long/short strategies, and leveraged global strategies. Some of the financial instruments unavailable to the small investor included commodities, financial futures, foreign currencies, and swaps. The growth of the hedge fund industry attracted some of the best and brightest portfolio managers. As a result of the benefits of highly talented portfolio managers, attractive returns, and the ability of the fund to manage risk, sophisticated investors moved large amounts of money to these private funds even though these funds charged a premium price for their services.

Through the years investment markets evolved, as have the regulations controlling what funds are allowed to do and invest in. Today mutual funds and ETFs are permitted to use many of the same financial instruments once reserved only for sophisticated investors. This means that individuals are able to access many of the markets, strategies, and financial instruments once only available to those able to meet the high minimums and restricted liquidity required by hedge funds. This is driving more benefits to individual investors than may be evident on the surface. For example, some of the elite portfolio managers are now coming out of the hedge fund industry and entering the mutual fund and ETF industry. This migration of money and talent means increased mutual/ETF fund capabilities and lower industry costs, which are passed on to investors in the form of lower fees.

This reminds me of another article I read this past week from Bloomberg, which reported that Harvard Endowment is letting go of about half of its 230 investment staff as it closes internally operated hedge funds. The article also mentioned that Harvard Endowment’s largest single holding is now the iShares iBoxx High Yield Corporate Bond ETF. According to the article, the endowment will shift much of the portfolio management to a growing number of outside money managers. This is not much different from individual investors selecting managers to manage their assets in investment accounts of all types.

Phil Mackintosh and Rachel Liang of KCG reported some interesting fund facts in a section of their morning comments on May 22, 2017: There is a common belief that retail investors are taking money out of stocks and buying domestic equity ETFs. In fact, over the past 10 years, investors have pulled $2 from stocks for every $1 invested in domestic equity ETFs. The balance of the dollars raised from stock sales went into bond and international equity ETF purchases. This also suggests that retail investor buying of domestic equity ETFs has not driven stock prices higher because there have been more individual stocks sold than bought via ETFs.

Regulatory Update: Last week the SEC decided to review the previous staff approval of the 4x leveraged funds that I reported on last week.

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.

Weekly Edge: ETF Relative Strength Signals Investors’ Economic View

Watching the relative strength of sectors can provide insight into investors’ views on the economy and specific sectors. Relative strength can offer clues about changes in investors’ views often well in advance of changes in the economy. Last week news related to the Justice Department’s appointment of a Special Counsel shook investors’ confidence in the market. While this was not economic news, it did send investors scurrying for defensive positions. The selling was noteworthy in magnitude, but it was relatively short-lived. As a result, there were not a lot of large changes in relative-strength rank last week. Most of the larger changes were related to news items, not big-picture changes in investors’ view of the economy or markets. Illustrating this on the domestic front are the sectors and factors that benefit from a growing economy, which are still among the leaders. Internationally, just as they were before last week’s news, investors are favoring non-U.S. regions.

Overall, there was a modest reduction of positive momentum in sectors, factors, and global regions. This suggests that investors this past week were not inspired to make large changes in their generally positive view of markets, even though they did react to the news on Wednesday. The weeks ahead will be telling, as investors either continue to let their enthusiasm for stocks diminish or increase their commitment to the leading bullish sectors and generally lift the momentum of all sectors.

Sectors: The leading Sector Benchmark ETFs for the past several weeks suggest that the economy is growing and expected to continue growing. Investors have been favoring the bullish sectors of Technology and Discretionary. This week Utilities moved into the #2 slot, bumping Discretionary into third. Since Utilities is generally seen as a defensive sector, this is possibly due to investors reacting to last week’s news. Health Care moved down a notch to fourth as a result of Utilities moving up. Investors see changes in health care legislation as a positive for many health care companies, so it remains near the top of the ranking.

Telecom, Energy, and Financials were the lagging sectors. These lagging sectors may be explained more by special situations than by economic expectations. Rising interest rates and industry-related legislation may be taking the glow off Financials, price wars are affecting Telecom earnings, and an oil glut is holding down energy prices. The leaders and laggards have not changed much in recent weeks, which may be a sign that the long-term bullish economic or market expectations of investors haven’t changed much. The general lessening in momentum is a sign that enthusiasm is declining but still bullish.

Factors: Momentum and Growth remain the top factors among our Factor Benchmark ETFs again this week. Low Volatility moved up into third, likely in a defensive response to last Wednesday’s market-moving news item. Along these lines, Small Size moved down three spots. This is noteworthy because this is often considered a bullish sector. Its decline is also likely linked to the news event more than a shift in the economic and market views of investors.

This alignment of the types of sectors and factors at the top of the ranking is a reinforcement of the view that investors have of the economy and the market. This is important insight because investors tend to invest with a view of the future while occasionally reacting to present news events—as was the case last week. Factors, as a group, also experienced a general decline in momentum this past week. When investors become concerned about future economic growth, we will see our rank order change significantly as investors seek defensive, rather than offensive, sectors and factors.

Global: There was a lot of activity among the Global Benchmark ETFs. The largest change appears to have been driven by the extreme weakness in Brazil and its impact on Latin America and emerging markets. Latin America fell five places to last among the 11 global regions. Again at the top of the global ranking were non-U.S. regions such as Eurozone, UK, and EAFE. UK moved up two spots to second place.

The weakest global regions were Pacific x-Japan, Canada, and Latin America. USA came in eighth. This indicates that global relative strength remains in the non-North American markets of the world. This relative-strength leadership in foreign markets may be partly attributed to the weakness in the U.S. dollar and a reallocation by institutional investors back to normal weights in foreign equity positions that were underweighted for an extended period of time.

This week five of the 11 leading Global Benchmark ETFs had momentum scores above 20. This is down one from last week. However, it is still noteworthy because there is only one score above 20 in each of the sector and factor lists. So, the relative-strength action remains in the Global Benchmark ETFs this week.

Weekly Edge 052417, Sector Edge, Factor Edge, Global Edge, Invest With An Edge

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.

“ETFGI, a leading independent research and consultancy firm on trends in the global ETF/ETP ecosystem, reports today that the global ETF/ETP industry with $3.913 trillion in assets at the end of Q1 2017 was $847 billion larger than the global Hedge Fund Industry … (based on ETFGI and HFR data).”

—ETFGI newsletter, May 18, 2017 (as quoted in Seeking Alpha)

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