Electronic Traded Funds are the Future of the Market

Electronic Traded Funds are the future of the Market

Will Mutual funds be able to survive in Developed markets like US.

With their low costs and tax-friendly trading, ETFs have transformed US markets and are taking over other developed markets with this the popularity of this is increasing in the emerging markets

Stock markets have a new purpose. Once devoted to trading stocks and setting their prices, they are now the venue for buying and selling something other than shares: exchange traded funds.

ETFs are taking over markets. Shares in Apple, the world’s biggest and most heavily traded company, turn over more than $3bn each day. But that is dwarfed by the biggest ETF, State Street’s SPDR S&P 500, which trades more than $14bn each day. Five of the world’s seven most heavily traded equity securities are ETF's.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, and ETF's now account for nearly one-half of all trading in US stocks and may other developed markets have a large percentage of trade via these funds. It is not just in trading that ETF's dominate. Their assets under management were negligible 20 years ago, but now exceed $3 trillion. They hog flows of new money and are revolutionizing the business of long term saving, once led by traditional mutual fund groups. Over the past 12 months, $130.7bn has flowed out of all US mutual funds, while $240bn has flowed into US ETF's.

In my opinion they are the structure that people will use to get exposure to securities in future, and mutual funds will be banished to the dustbin, like typewriters have been replaced by computers. It’s just a better technology and so it will come to replace funds over the next 20 years.

Both mutual funds and ETF's are collections of securities packaged into a fund. Almost all ETF's track an index, like passive index tracking mutual funds. The difference is that mutual funds are open-ended investors can pay directly into the fund or withdraw from it. This is done once a day, at prices set at the close of trade. With an ETF, investors buy and sell shares without directly adding to or taking away from the fund itself. Instead, the shares trade on an exchange and market makers buy, sell and create new shares to ensure they move in line with the value of the fund.

The advantages, as far as investors are concerned, are twofold. First, they can buy or sell at any time of the trading day, at the latest price. Second, the fund itself bears fewer costs. And in the US there is a third advantage: ETFs’ tax position is superior. Once such provisions are available in other developed and developing markets the net overall yield on such funds would increase and there by the popularity would increase any fold.

Yet as ETF's have grown, so have the worries about them. Could ETF's dominance create new systemic risks, or trigger another market crisis? Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.

The idea that they have underlying liquidity, seemingly whatever the asset, was always a rather dangerous one, and as they grow ever bigger I would suggest this is something regulators might like to look at, especially in a market like India where the market regulator SEBI is very conservative and the overall penetration of the equity markets on the whole is not very large having a limited market depth.

However, the ETF structure has now survived several bursts of market turbulence without causing system wide problems, and they may in any case not yet be big enough to have a systemic impact.  ETF's still have less than 5 per cent of the total investment universe, when measured by the assets they manage.

By themselves, ETF's do not as yet have the critical mass to kick-start a systemic crisis, in my opinion.  But I strongly feel that they do have the ingredients to create a snowball effect, once markets go south decisively. They do appear to lead markets now, rather than mirror them.

Since the financial crisis, markets have been dominated by politics and attempts to second guess central banks. By allowing investors to make focused bets on sectors or asset classes with the click of a mouse, ETF's have made this kind of trading much easier.

ETF's have been a very efficient way to play these themes that are running in the market at present and an overall broad play on such themes is easier to execute by the EFT structure, which are trickier for stock pickers. But whether ETF's have been behind these trends is open to question. Preliminary evidence from the remarkable market action that followed Donald Trump’s election in the US, which saw sharp moves upward for stocks and downward for bonds, suggests that ETF's may indeed be encouraging short-term movements. Since the election have already been enough to make it “the most concentrated asset allocation shift in history.

In the two weeks between the November 8 election and the Thanksgiving holiday, about $50bn flooded into equity ETF's while roughly as much capital abandoned fixed income funds. In the past, investors would have needed to pause to think through which of their stocks might be most affected. Now, ETF's allow them to make sweeping bets on sectors at the press of a button.

About 20 per cent of equity flows went into the financial sector alone in just 12 trading days. The market values of two ETF's that cover only financial stocks rose by 46.5 per cent and 31 per cent respectively.

This buying will have raised all the stocks in the index tracked by the ETF's equally. That implies that some of the weaker banks will now be under priced, while others are overvalued.

With this kind of flow and money flowing in EFT’s there’s little opportunity for people who are looking at a stock from the bottom up, rather than the top down from an ETF, in my opinion.  It makes the large stocks in the ETF's very inefficient because you get a constant inflow to the companies in the index.

Stocks now tend to move close in alignment with each other most of the time, and then divert sharply in response to corporate announcements. News has always had an impact on stocks, but this pattern has grown far more pronounced since the advent of ETF's,

The flow of ETF's will mask any issues in a big company’s business. The flow from ETF's into IBM, for example, is more appealing to investors than IBM’s business. Therefore you get greater reactions to corporate announcements whenever they happen.

This trend of rising correlations has serious consequences for active stock pickers, who will select bargains and then find that their stocks stay cheap.

Combined with the swift moves in markets, this has created an environment in which active investors have persistently under performed since the crisis. Clients have punished them for this, with some $336bn flowing out of US active funds in the past 12 months.

It also makes it harder for smaller companies to raise capital. Investors moving money through ETF's tend to put capital into the biggest companies with the biggest weight in the index. Others go without.

In particularly in relatively ill liquid and inefficient markets such as some emerging markets the fast turnover can create problems especially in markets like India where the overall market depth is limited and even though there are around 6,000 companies listed on the nationwide exchanges the market of which market depth is really present only it the top 500 companies out that 12 per cent of a typical stock turns over each year, compared with 880 per cent turnover for ETF's.

ETF, run by some major funds like Black Rock, turns over some $2.6bn each day, more than any individual stock bar Apple. Emerging markets tend to be dominated by a few large, partially state controlled companies, which automatically receive a large chunk of ETF money because of their weight in the index. Capital is hard to find for smaller companies which may otherwise look more attractive. This has led active managers to allege that the rise of ETF's and passive investing are making markets less efficient.

 In my opinion indexing increases as a proportion of assets, correlations between stocks do increase. Stock markets aren’t where capital gets allocated. It gets allocated in IPOs [initial public offerings] and secondary offerings.

Another area of concern is a change in the ownership structure of companies. ETF's and passive mutual funds are primarily taking business from actively managed mutual funds, which are the bedrock of the way people around the world save for retirement. Planned regulatory changes in the US are likely to accelerate the trend by pushing brokers towards selling lower price funds which means ETF's and passive mutual funds.

ETF's are a scale business and they work on economies of scale.  The more money they can attract, the lower the costs and the higher the profit margins  meaning that a few companies, all based in the US, have come to dominate. The top three hold more than 69 per cent of all ETF assets, or more than $2.3tn, between them. BlackRock, the world’s largest fund manager, is by far the dominant ETF provider, followed by Vanguard and State Street. These companies are now leading shareholders in virtually every large public company on the planet.

Active managers traditionally take a vocal role in corporate governance, and complain that this will no longer happen under ETF's a charge that the largest ETF issuers indignantly deny, saying that they can only protect their interests by taking an aggressive attitude to corporate governance.

But it is undeniable that the ETF revolution has left corporate ownership far more concentrated. The responsibilities of stewardship and overseeing corporate directors have been ceded to a few large companies.

Against this, they have opened up assets such as bank loans or emerging markets or commodities to retail investors, and even to institutions, that were effectively closed before. Gold, for example, is now far easier to trade, without the need to take possession of gold coins and guard them. Some $27bn in shares in the largest gold ETF change hands every day. And they have certainly brought down costs for investors.

It is clear that ETF's are bringing more liquidity and transparency to savers and that they are enabling small savers to invest at a very low cost, in my opinion.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, ETF's are just a better technology and so they will come to replace mutual funds over the next 20 years

_ Farzan Ghadially 

Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

The US Federal Reserve will meet in a couple of days  and I  expect it to  increase interest rates. This would mark its only hike in 2016, despite early year indications of many more. The path thereafter is less clear, though growing reflationary forces, reinforced by a probable fiscal expansion under US president elect Donald Trump and new appointments to the Fed board, could imply a more hawkish central bank down the road.

In any case, I believe government bond yields have seen their lows. The 35-year bull market in bond prices is facing sunset; higher yields and steeper yield curves are on the horizon. Income seekers, for years tormented by low bond yields, may welcome the prospect of rising rates.

Yet structural changes to the global economy, ageing populations, weak productivity and the debt overhang following the financial crisis are a notable offset. These should limit growth and, with a glut of savings in emerging markets, put a cap on how high rates go. As such, yields are likely to reside in a lower range than they have historically.

That means investors should not turn away from equities for income. I believe dividend growth stocks remain one of the most fertile fields for income seekers. Equities become the key income source as low economic growth and excess global savings helped push bond yields to record lows. Equities today provide more than 70 per cent of the income in a global 60 per cent to 40 per cent stock-bond portfolio, my analysis shows, even after the recent rise in bond yields. This compares with an average of just 46 per cent since 1990.  I expect equities to remain the key source of income for investors even as bond yields rise.

A rise in rates could hurt high yielding dividend stocks with premium valuations and low growth rates, so-called bond proxies. Yet it does not weaken the case for all dividend paying equities. In fact, it reinforces our preference for dividend growers.

As overall portfolio returns are likely to be lower over the next five years, dividend income is likely to become a larger component of return. This is particularly true when you consider that bond yields have bottomed and stocks have little room to run amid high valuations and tepid earnings growth.

I see dividend growth stocks, quality companies with enough free cash flow to sustain dividend increases over time, having an upper hand in this environment. They are less susceptible to rising rates than high yielders.

Dividend growers also have a clear return advantage relative to bonds. As rates rise and bond prices fall, many of these stocks could generate positive returns thanks to the power of compounding dividends and earnings growth. My analysis shows valuations of global developed stocks would need to fall some 30 per cent over the next five years to generate negative returns, a very unlikely scenario.

Part of the reason bond yields are rising is that growth and inflation expectations are rising. Higher inflation expectations also favor dividend growth companies, which are typically able to raise prices, and payouts, in reflationary environments.

Both the search for income and the strong case for dividend growers are global trends. Yield opportunities are scarce throughout the world, and the need for equity income remains high as retired populations increase and investment income is challenged to supplant pay cheques.

But dividend growth opportunities exist across sectors and regions. US financials, for one, may have appreciation potential given the steepening yield curve, the prospect of looser regulation and investors filling long-held sector underweights. In addition, I can see US bank revenues benefit more than in past rate-hiking cycles as the Fed raises rates slowly. With little competition for deposits in this cycle, banks should be able to earn more on loans without a commensurate increase in deposit rates.

One tailwind for US investors may be tax reform. If a repatriation tax on US earnings held overseas were enacted, US companies’ cash flows would enjoy the windfall, a potential positive for dividend growth. Technology stands out in this regard.

Rising bond yields are a headwind for income stocks. But I believe a focus on dividend growth is still likely to offer both income and potential for attractive relative returns.

-Farzan Ghadially

Big Impact of Demonetization across sectors like Retail, Real Estate and Banking

Big Impact of Demonetization across sectors like Retail, Real Estate and Banking

A few weeks after Narendra Modi, India’s prime minister, declared 86 per cent of the country’s bank notes invalid overnight, corporate India is only beginning to understand how the move is likely to change the way companies do business.

For many, the measure could prove historic. Digital payments companies, for example, are reporting that demand for their services has increased several hundred per cent, and some have brought forward their growth targets by a year or more.

Other sectors have more reasons to worry. Consumer goods companies are trying to determine whether the short term interruption to sales, which are often made in cash, might lead to a more protracted downturn and there is a property slump that might last for over two years.

For the economy, as a whole, my  prediction is  that this will pause growth, which has been running at more than 7 per cent a year. The Sensex share index has lost 6 per cent since the announcement, falling under 26,000 for the first time since May.

Many economist, have described the move as being like shooting at the tyres of a racing car.

However the long-term implications might yet be positive, if the government can use some of the extra revenue it expects to garner from the measure to offer a fiscal boost, such as sweeping tax cuts in next year’s budget, by giving more funds in the hands of people to send rather than trying to increase the government spending as it would take its own time and the result would be rather very disappointing.

If that does happen, by giving more breaks to the people on the whole I  expect much of corporate India to recover after the turmoil. But whatever happens, different sectors are likely to feel the benefit or the pain to very different degrees.

Banks

Beleaguered bank staff might not feel it right now, but demonetization is likely to prove a major boost to their banks balance sheets, as a slew of money that might have otherwise stayed as cash is now deposited.

My estimate is that 80 per cent of the country’s notes will return to the banking system, which will increase deposit growth by up to 10 per cent.

Of which I expect about half of that to stay in the system long term, which would increase pretax profits — especially at public sector banks that usually have bigger retail networks  by up to 15 per cent.

The problem for all banks, however, is that both consumer spending and the housing market are expected to slow in the next few months as people rein in their spending and companies struggle to keep their supply chains going without cash.

These competing pressures have sent Indian bank stocks on a rollercoaster ride. Shares in State Bank of India, for example one of the biggest public sector lenders initially climbed 12 per cent in the first few days after the move, but have since fallen back 9 per cent.

Consumer goods

Consumer goods companies are counting the cost of the sudden shortage of cash. From items as small as medicines or household goods to larger appliances such as dishwashers or washing machines, much of India’s consumer economy runs on banknotes.

 Sale of white goods items such as air conditioners and TVs, almost 40 per cent of such purchases come via cash which will be hot major time due to this move.

Luxury consumer goods would be hit even harder as a large part of sale is this segment is done using cash and a major hit is anticipated.

Even companies with large financial clout are having to adjust. A number of multinational consumer companies have started   renegotiating credit terms with its small-scale distributors around the country that have seen sales collapse.

Property

India’s property market is likely to be one of the hardest hit from demonetization, not least because buying or building houses has been the most common way to launder black money. But due to the fact that 15 or 20 per cent of real estate transactions in India involve illicit cash.

My estimates are that It may take several years for currency to normalize in the ‘black’ economy. This would slow down transactions, and hurt prices of real estate and land.

However bigger, more reputable developers will be unaffected, given that most of their transactions come via bank loans. Larger companies will also be able to take market share from smaller rivals in the long term. Hence the larger and well established developers who have systems and processes in place would benefit at the cost of the smaller developers.

The secondary sales market in real estate would slow down major time and the kind of slow down would be in place for the next 2 to 3 years.

Hence the real-estate industry that was already in the ICU has been put on the ventilator and days to come would be very hard. 

Ecommerce

While bricks-and-mortar retailers struggle to attract customers many of whom are instead standing in line at the bank  this should be an opportunity for India’s ecommerce companies to hoover up market share.

Executives from many of those companies, including Amazon, Flipkart and Snapdeal — India’s biggest online retailers — have welcomed the move. But in the short-term business has suffered, mainly because about 70 per cent of online commerce in India is paid for by cash on delivery.

The trend in the last week or so after the immediate shock is seen that   the fall in cash-on-delivery transactions has offset the rise in card payments. While business from the larger towns and cities has gone up, overall sales fell 7 to 8 per cent following the government’s announcement.

Several online platforms have even put temporary restrictions on purchases paid for by cash on delivery. Others are offering discounts on card transactions.

However, many are optimistic about what this could mean for the online market in the long term.

However the reality so far is that the 6% fall in the Sensex index since large bank notes were declared invalid 70% Amount of online commerce in India paid for by cash on delivery and this would take a major impact on the online business as the cashless penetration would be reasonable in Metros and larger cities but in tier 2 and tier 3 cities the preferred form of payment is cash on delivery which would take a long time to normalize and the impact would be felt on the overall numbers.

_ Farzan Ghadially

Present Cash Crunch will not have a major impact on curb Black Money Campaigns

Present Cash Crunch will not have a major impact on curb Black Money Campaigns

Indian prime minister Narendra Modi’s surprise ban on Rs500 and Rs1,000 notes was designed like a game of musical chairs, intended to catch out Indians with stashes of illicit black money, earned through corruption or simply hidden from tax officials. Estimates state that black money stored in notes is any where between 6 to 13 % only, hence the pain seems to be more than the overall gain in this exercise. 

Until November 8, black money was circulating merrily through the economy, powering purchases of luxury apartments, gold jewelry, foreign holidays, lavish weddings, and more. But with New Delhi’s overnight ban on using the high-value bank notes and its proclamation that notes not turned in to banks by December 30 will be worthless pieces of paper; the music abruptly stopped.Hence any person who holds the so called black money would end up laundering the amount by taking a discount which in being reported in the market anywhere between 25 to 40%. Banks so far have reported that almost 5 lac crs has been deposited/ exchanged so going by this trend by 30th December if this figure really swells the question is where was the black money ? The problem is banks would report total deposit/ money exchanged however India being such a large agriculture economy a farmer can go to the bank and deposit the money claiming that it is his money which would be treated as tax free and would be withdraw at a latter date and could be returned to the original providers of the monies after the charges as a discount. 

Another problem is in order to change these notes and launder the black money the route of gold could be used there by increasing demand for gold import there by rupee pressure on the rupee which could have long term impact of the trade balance of the country. We have already seen with two weeks the volatility in the rupee, almost touching 69 to the $. 

Indians with illicit cash squirreled away face a choice of acknowledging their hidden wealth or losing it, unless they can circumvent the system. Among those hard hits are Indian politicians who rely on hidden slush funds provided by donors to finance their costly election campaigns.

It is probably no coincidence that the clampdown on cash comes just as Uttar Pradesh, India’s largest state, is gearing up for important state elections, whose outcome could influence Mr Modi’s own re-election prospects in 2019. The opposition parties have made claims that there is no question that part of his motive is to choke off funds to the rival parties and this would swing the UP elections in favor of BJP.

Political parties’ rapacious demand for cash for electioneering has long been seen as one of the major drivers for Indian businesses to generate and maintain large stashes of black money, hidden from tax officials’ eyes. Mr Modi’s own glittering, high-tech 2014 national election campaign is thought to be one of the most expensive. The political system needs the lubrication of money and which every party can provide this lubrication would end up doing better than the rest in the elections.

During forthcoming state elections, parties especially in opposition will undoubtedly face problems, as political funding dries up. Furious rivals of Mr Modi’s ruling Bharatiya Janata party claim it had advance notice of the move that rendered 86 per cent of India’s cash supply virtually useless.

But the cash crunch is unlikely to purify India’s democracy without substantive reforms to bring transparency and accountability to its opaque campaign finance system.

It will make a one-time dent in election spending, but it’s not going to have any long-term impact because you are just going to regenerate black money.

India’s political parties have been hooked on secret donations since the decades after independence, when extensive state control over the economy encouraged businessmen to foster strong ties with political elites.

Political funding grew more opaque in 1969, when then prime minister Indira Gandhi banned corporate donations to political parties.

As the incumbent with all that power, the Congress would find ways of twisting people into giving below the table, but others wouldn’t have those benefits, Modi’s calculation is somewhat similar as it seems. 

Though corporate contributions were made legal again in the 1980s, political parties still closely guard the identity of their donors.

India ostensibly has strict and, many argue, unrealistically low campaign spending limits, but they too are riddled with loopholes, applying only to individual candidates, and not to parties. Parties’ financial accounts are not subjected to any independent auditing either.

Amid the disruption unleashed by his currency ban, Mr Modi has talked a good game about purging black money from the economy. But until political parties, including the BJP, are compelled to lift the veil of secrecy over those pumping monies into their coffers, India’s democracy will remain infected by black money

It will make a one-time dent in election spending, but have no long-term impact. 

_Farzan Ghadially

The Volatility shock till 8th November

The Volatility shock till 8^th November

History will be rewritten and the World Markets would get direction on 8^th November when US elections will be held ...Till then be prepared for a lot of Volatility in markets all over the world.

We had our October surprise, and it should not have been surprising. We should also be prepared for a November surprise, and treat rising volatility in the week before the US election as a racing certainty.

What is beyond doubt is that the markets are scared of a victory for Donald Trump. Volatility remains low, but the Vix index has risen sharply twice since June’s Brexit vote on September 12, after Hillary Clinton was taken ill and admitted having pneumonia, and this week after a tracking poll showed Mr Trump in the lead.

To deal with this we must break the issue into component parts. First, who is going to win, with what probability? Second, is that probability priced in? And third, what effects would each outcome have on markets?

Note that the outcome is not binary. A Clinton victory may be accompanied by control of the House, while a Trump victory could be accompanied by Republican loss of the Senate. There are also possibilities that Mr Trump does not accept a defeat, or of a constitutional crisis following a tie in the electoral college extreme and unlikely events that would spell disaster for global markets.

So, who is going to win? Prediction markets capture prevailing opinion and put a number on it. They may not be right, but they express the prevailing wisdom. Growing publicity for their remarkable success in calling elections.

There are different markets, but all show remarkable assuredness that Mrs Clinton will prevail. PredictWise, which aggregates prediction markets, has never shown the Democrat’s chances as lower than 72 per cent and puts them at 84 per cent. But this conceals a wide variation. PredictIt shows Mr Trump’s chances doubling in the past week to 37 per cent. The Iowa Electronic Markets, the longest continuously operative prediction market, which is less liquid than some, shows Mrs Clinton’s chances at only 57 per cent.

Latest polls show her advantage in the RealClearPolitics average falling to only 1.7 percentage points, from 7.1 percentage points two weeks ago, and behind in Florida, Ohio, Nevada and North Carolina. That makes the prediction market odds on a Trump win sound generous.

It therefore looks as though the probability of a Trump victory remains under-priced on markets, and could easily swing wildly in the next few days. It is a property of betting on a binary out come as the event approaches, there is less time for a bet to pay off. That means volatility will rise. If anyone betting on Clinton has doubts, they have only a few days to sell, and doing so will depress the price further. Big swings in prediction markets in the last few days of a campaign are the norm.

The impact? Markets have not moved much so far in part because it is unclear what a win for Mr Trump would mean. His policies are unclear. This intensifies the chance of risk premia rising. But US Treasuries are havens. People buy them even on news that is ostensibly bad for the credit of the US. Treasury prices rose in 2011 after Standard & Poor’s downgraded their credit rating. So victory for a man who says he might deliberately default on Treasury debt might lead people to buy more US government paper.

A further issue is that Mr Trump might try a big fiscal stimulus, with infrastructure spending and tax cuts. This would mimic Ronald Reagan, and imply a strong dollar and higher bond yields which might be good for the US economy but terrible for international asset prices.

So, the next week is perilous. A little gold, or some Vix futures, might be a good idea, treated as an insurance premium. Volatility could easily rise far higher from here. And within reason, it is good to hold cash. It gives optionality. Cash can be rapidly redeployed, and that is appealing.

Finally, Trump futures offer value. Anyone who bought one for 9 cents on the dollar on the Iowa market two weeks ago has made a 365 per cent profit, and should consider selling. But some exchanges still put his chances below 20 per cent.

Trump futures have made a 365% profit in two weeks consider selling and taking home the profit.

The VIX in the Indian market would rise to a great extent as Trump victory could impact many sectors like IT and IT related, Pharma etc ... which have a great exposure to the US market in a big way and would lead to a correction in the market with a period of uncertainty till the time there is complete clarity on way the Trump policies would shape out or were they just election promises. In case of a Clinton victory, there would be a mild positive for the markets for a few days and then it would be treated as a non-event as no major change in policy is seen that would make any material impact on any sector as such. Hence there would be lot of volatility in the markets till a real clear picture emerges.

_ Farzan Ghadially