Have The Banks Finally Outsmarted Even Themselves?

For as long as we can remember, financial institutions have always come out on top. This was particularly evident after the 2008 financial crisis. They profited greatly from selling toxic sub-prime debt instruments that nearly took down the global financial system, forcing an epic financial bailout that cost taxpayers billions. Yet the survivors continued to be handsomely paid (relative to the rest of the economy) in the years that have followed.

These financial innovators continued with the strategy of “what makes us rich is all that matters” by developing and pushing investments into Exchange Traded Funds (ETFs) that have now overtaken financial markets.

What are Exchange Traded Funds (ETF’s)? They are open end index funds that can be bought and sold as you would any stock. They represent an index of securities that trade in the public markets. For example, you can buy an ETF of a country (i.e. the U.S.), or an industry (i.e. technology), or even a sub group of an industry (i.e. the FAANG stocks). The biggest advantage over other traditional index funds or even mutual funds (who rarely beat the markets they represent) were much lower fees. It’s been an easy sell.

ETFs started out as alternatives to mutual funds for retail investors trying to get exposure to market funds at lower fees, but today they are also being used by many institutional investors. According to BlackRock, assets in ETFs are at a staggering $4.7 trillion. BlackRock projects that this number could be as high as $12 trillion by 2023. They have become an enduring investing trend, with assets in global ETFs growing at an organic annualized rate of 19% from 2009 to 2017. Accompanying this trend have been severe consequences for all of capital markets.

As the traditional bank/broker model has transitioned to a fee on asset model, the cost of investing has come under scrutiny. Further, in order to avoid lawsuits for choosing the wrong stocks for clients, financial advisors have aggressively pushed ETF investing onto their clients by just using simple asset allocation strategies. This is all grounded on the fact that asset allocation is considered more important than the security selection decision for the most optimal risk adjusted returns. ETFs are well suited for this because they are liquid, low cost, transparent and can provide exposure to many different industries and markets. The only thing that cannot be replicated with index based ETFs are portfolios that seek to provide Alpha (which is how Summerhill Capital invests).

Mutual funds, which are just closet indices with large fees, have been highlighted as detrimental to long term returns compared to simple index/ETF investing. There have also been endless news articles on how active stock picking can erode long term returns because of all the costs incurred. Robo-advisors, the new rage, also provide ETF focused portfolios as they are more cost effective for dealing with smaller investors, resulting in higher profits for the advisor. Rotation out of traditional active investment funds is therefore likely to continue.

Banks are well aware of these trends and have been able to capitalize on this by producing all sorts of ETFs of their own, and aggressively encouraging their wealth management advisors to push them to their investor client base. ETF investing also helps the banks to stay away from nasty lawsuits brought about by rogue advisors who in the past were not following their fiduciary duties and invested their client assets in stocks that were not appropriate for those clients. Lastly, as new rules enforce transparency of fees by all independent financial advisors as well as fund companies and banks, it naturally will tend to steer everyone to focus on the lowest cost products available in the market to avoid criticism.

There are however problems inherent with this trend of putting funds into passive investment strategies, where instead of owning the best stocks, investors try and pick the best industries or countries for a period of time.

First of all, invariably this will lead to price distortion in the underlying stocks. Prices for a basket of stocks in an ETF should be determined based on the value of each underlying security. But when index prices are being set by top down investors who want exposure to an industry or particular group irrespective of price, then all the stocks get the same treatment regardless of whether the underlying companies are doing well or not.

Second, this is not really investing, it is trading. Bets are being made on sectors of the economy or particular countries, rather than participating in the growth of a particular company because they have the best product and management. Index investing is very rewarding and good fun when markets are in an uptrend as they have been for most of the past decade. It however, turns ugly very quickly when markets turn down, as investors do not really know what they own, and usually panic out at precisely the wrong time. Or they are stuck with poor performance as the bad companies can outweigh the good ones in any index, given enough time. The endurance of this trend will not be tested until a significant bear market gets underway. One can only hope that when it does, and investors panic out, that liquidity issues are not such that they exacerbate the problem. But this is a concern for another day.

Last, but not least, is that capital markets were created to provide funds for companies to grow. If investors have no interest in the underlying companies that comprise any particular index, there is nobody in the public markets to provide those funds to companies for capital expansion and future growth. All new companies are forced to deal with private equity funds for any capital needs.

This could be a huge problem for banks when you consider that a large part of their business came from investment banking which basically focuses on bringing companies to the public markets for capital. The prevalence of low fee ETF investing could therefore in fact kill the goose that has laid the golden egg for banks for the past century. If you consider the fact that institutional trading is now being replaced by computers with algos, who is left to be paying for all that expensive research that banks produce? So it is not just investment banking that can disappear as a profit centre but institutional research, sales, and trading are also likely to become redundant over time. Given that ETFs pay very low fees it is hard to see how the banks have not shot themselves in the foot as they replaced highly profitable businesses with low fee profit centers at best.

Going into an era where Fintech is already taking share via new competitive online offerings such as the payment processers like Paypal among others, and many of the traditional banking businesses are being dis-intermediated, this trend in wealth management could prove to be highly problematic for banks and be the final proverbial nail in their coffin.

We will have to wait and see what the brightest minds in finance will decide to do for an encore, but this industry is about to get very interesting and worth watching closely both for potential losses and new opportunities.