July 1, 2016

By David Snowball

Dear friends,

Hi. We’re back. Did you miss us? Chip and I greatly enjoyed our holiday in Scotland; she’s the tiny squidge in the middle of the picture, smiling and waving at you. This shot captures much of the delight of our time there. It’s taken from atop Dun Beag, the remnants of a 2,400 year old fortified keep near Struan, on the Isle of Skye. It’s on the edge of a pasture that stretches for miles, up mountains and down ravines. Sheep grazed all about it, studiously ignoring us. It looks out onto The Inner Seas that separate Skye from the Hebrides. 

dun beag 1

atop dun beag

Chip adds, “And here’s our fearless leader, perched atop Dun Beag, enjoying the glorious views and perfect weather.”

We stopped and hiked here a bit on my birthday, on our way to dinner at the Edinbane Inn. I’d share a picture of our dinner, but then you’d drool on your keyboard and that can’t be good. Continue reading →

Funds in Registration, July 2016

By David Snowball

Anchor Alternative Equity Fund

Anchor Alternative Equity Fund will pursue total with a secondary objective of limiting risk. It will be a long/short fund-of-funds investing in ETFs and mutual funds.  Here’s the key phrase: “The Fund primarily takes long and short positions in securities that are highly correlated to major US equity indices based on long, intermediate, and short term trends.” The fund will be managed by Garrett Waters of Anchor Capital Management. The initial expense ratio is 2.77%. The minimum initial investment is $2,500.

Anchor Tactical Real Estate Fund

Anchor Tactical Real Estate Fund will pursue above average total returns over a full market cycle with lower correlation and reduced risk when compared to traditional real estate indexes. It will be a long/short fund-of-funds investing in ETFs and mutual funds.  They’ll invest in real estate funds based on their analysis of trends, with the prospect of hedging against broad market declines with short ETFs. The fund will be managed by Garrett Waters of Anchor Capital Management. The initial expense ratio is 3.10%. The minimum initial investment is $2,500.

Cornerstone Core Plus Bond

Cornerstone Core Plus Bond will pursue total return, consisting of current income and capital appreciation.  The plan is to farm the work out to 12 people representings several different famous firms. The initial expense ratio is 0.49%. The minimum initial investment is $2,000 but it’s available only “to certain advisory clients of the Adviser.”

Low Beta Tactical 500 Fund

Low Beta Tactical 500 Fund will seek to outperform the S&P 500 with lower volatility than the Index.  The plan is to invest either in S&P 500 ETFs or cash based on “tactical research, analysis and evaluation regarding market trends.” The fund will be managed by Thomas Moring of LGM Capital Management. The initial expense ratio is 1.95%. The minimum initial investment hasn’t been disclosed.

Schwab Target 2060 Fund

Schwab Target 2060 Fund will pursue capital appreciation and income by investing in other Schwab and Laudus Funds.  Zifan Tang, Ph.D., CFA, a Managing Director and Head of Schwab’s Asset Allocation Strategies, is responsible for all the funds in the series. The expense ratios have not yet been released. Ironically, the funds do not carry 12b-1 fees, which are usually the price for getting carried on the Schwab platform. The funds are only open to institutional investors but for those investors the minimum investment is $100.

Schwab Target Date Index Funds

Schwab Target Date Index Fund will pursue “capital appreciation and income consistent with its current asset allocation.” These will be funds-of-ETFs which equity exposure ranging from 95% (2060) to about 40% (2010).  Zifan Tang, Ph.D., CFA, a Managing Director and Head of Schwab’s Asset Allocation Strategies, is responsible for all the funds in the series. The expense ratios have not yet been released. Ironically, the funds do not carry 12b-1 fees, which are usually the price for getting carried on the Schwab platform. The funds are only open to institutional investors but for those investors the minimum investment is $100.

The Black Swan of Brexit

By Edward A. Studzinski

“A bank is a place where they lend you an umbrella in fair weather and ask for it back when it starts to rain.”

Robert Frost

By Edward Studzinski

The title of this month’s piece probably leads one to expect that I will be writing a review of a circa-1930’s costume drama film, set in either 15th century England or France, starring Tyrone Power, etc, etc. Sadly, the time is today. And while many of the players act like fictional characters in terms of temperament and self-interest, unfortunately they are not.

I expect many of my colleagues, especially David, will have a lot more to say about BREXIT than I, but I do think the matter of it as a black swan event is critical. In recent years, many have thought about the United Kingdom as one country, especially after the Scottish secession vote was defeated, without realizing that economically it was many. You have the city state of London and southeastern England, an area that rivals Renaissance Florence as a center of commerce, trade, wealth, culture, and the arts. And then we have the rest of England, which includes the southwest as well as the impoverished former industrial north of Manchester and Yorkshire, an area of high unemployment and rather daunting poverty. Similar segmentation plays out in both Northern Ireland and Scotland. So, the surprise is not that 52% of the population, in a 70% plus voter turnout voted to leave the EU, but rather that the politicians and pollsters got it so wrong.

At this juncture I will spare you the history lesson, but suggest that some digging, especially with attention to The Hundred Years War, will give you a greater appreciation of the back and forth between England and the Continent over a thousand years. And for those who keep making a comparison between the events of today, especially the rise of economic nationalism, and the events of the 1930’s, I will suggest that a more apt comparison is the 15th and 16th centuries, where you had the continuing conflicts between England and France, France and Burgundy, and the economic rivalries of the Italian city states of Florence, Genoa, and Venice. You also had the fall of Constantinople and then Trebizond marking the end of the Byzantine Empire concurrent with the rise of the Ottoman Turks and their empire. And while politics and religion were given lip service as to the primacy of place, the real drivers of events were economics, trade, and the greed for greater personal wealth.

So what investment conclusions can one draw from BREXIT? It is far too soon to tell. Obviously there is and will continue to be a ripple effect, which has already begun in terms of increased market volatility and dislocation. There will be winners and losers, in terms of economies and businesses. At the same time, knee-jerk reactions, either to sell investments or make new investments, are to be avoided. Those who liquidated investments in the first days of a global sell-off have probably realized losses that would not have been losses had they waited a few days longer. Those who ran in and purchased things such as European banks (thought to be undervalued before the BREXIT results) find that that they are still cheap and may become even cheaper. Over the last several months it had become clear that a number of large European banks were going to need additional help from their central bank counterparts. We see then the announcement in the last few days that one of the greatest potential sources of systemic risk to the financial system is Deutsche Bank.

In terms of real assets such as property and commodities, the fog of volatility is even thicker. I have a friend who is in the process of relocating from the UK to Switzerland, an unwinding that has been going on since the beginning of the year. The last piece was to be the sale of a home in London. The higher- end London market had already been somewhat toppy this year, with slowing sales. So, the process was dragging. This week she told me that as a result of last week’s vote, the market price that she had been expecting has dropped by 25%. In terms of commercial real estate, the short-term dislocations should be equally as great. London may appear to be a loser and locations such as Dublin, winners. Alternatively, if the British find their footing and resume being a trading and finance center for Africa and Asia, the property dislocations may be short-lived. At this point no one knows. And once again, investor time horizons matter.

A 25% move in real estate prices in one week is huge, and not easily recovered. Similarly, we saw a huge move in currencies last week, in particular the British pound sterling, by what, 15%, in a very short period? In markets which are zero sum events (for a winner there has to be a loser), we should be looking for some failures or liquidations to be announced in coming days.

And Now For a Word From …..

This brings me to a thought which will surprise many of you, given my previously expressed preferences for low cost, index products for most fund investors. This is almost the ideal environment for the active, long-term oriented value manager. The issue becomes finding that active manager who will put your interests first, above that of career and firm.

At the beginning of June, we were seeing active managers’ performance trailing the index funds (again). A friend related to me a conversation he had had with the director of equity research at an investment management firm that was seeing consistent outflows because of index-lagging performance for the year-to-date, one year, and three year periods (not surprising as most investment and financial consultants have a much shorter investment time-horizon than the one they advise their clients to have). This individual told him that even if the outflows continued and the assets under management dropped to X billions of dollars, he would not be concerned as there would be “more than enough money to go around.” So recognize the priorities here, which were on self-interest.

This is the humorous aspect of seeing presentations from investment firms about eating their own cooking, when the true focus is upon how much can be taken out of the business. For those who think these are random situations rather than episodic, I commend you to an article entitled “For the Love of Money” by Sam Polk which appears in the Sunday, January 19, 2014 Sunday Review section of the Sunday New York Times. The piece discusses the concept of “money addiction” and starts with this sentence, “In my last year on Wall Street my bonus was $3.6 million and I was angry because it wasn’t big enough.”

Think about it. The compensation of a Fortune 100 CEO is disclosed. All-in someone may get a combination of salary, bonus, benefits, and option/stock compensation tied to profitability that may come to perhaps $20 million dollars a year. This is a business with billions of dollars in revenue and profits, thousands of employees, and its performance can have a major impact on the national and global economies. Contrast that with the fund manager whose compensation all-in, for managing $40 billion of assets is $30 million dollars a year, she or he has perhaps forty employees and an economic footprint that is far less. And of course, the $30 million dollars a year is part of a shell-game that is played so that trustees of fund organizations see perhaps a $5 million dollar compensation number for the manager, with other amounts categorized as “ownership interest in the firm” or “long-term compensation pool” etc., etc. But wait, the firm is a wholly-owned subsidiary of an asset-gathering fund company? And people are surprised by how much support politicians like Sanders and Warren have garnered?

There is another game going on here as well, and that is on the parent side of such organizations.

I recently had a conversation with someone at an asset-gathering firm where we talked about the dislocations and shut-downs in the hedge fund and mutual fund industry. This person said to me, look, it is all about leveraging our distribution platform to gather assets. If the assets under management at a subsidiary don’t grow over a five to ten year period, we are going to either offer to sell it back to the subsidiary managers or shut it down. We are not in business to not make money for our shareholders.

I related this conversation to a West Coast-based fund manager who said to me, this explains why a friend of mine at another firm was faced with the choice of mortgaging his home and signing away his life. He was presented with the choice of repurchasing his firm at the price dictated by the parent or being shut-down. Depending on the state where you are doing business, you may face rather dire choices. California of course, has made non-compete agreements illegal. Not so, New York and other jurisdictions.

This brings me to my final point this month. There is a storm brewing that will sweep over the mutual fund business as we know it. The proposed rules from the Department of Labor which will make the financial advisors, the platform companies, and the funds fiduciaries will effect drastic change. On its face, the idea that an investment should be suitable for those purchasing it and the fees disclosed for that investment would appear to make sense. And yet the rules are being fought tooth and nail by the industry.

Have you ever wondered about the economics of purchasing funds through a discount brokerage account where there is a no-transaction fee fund supermarket? Who gets paid and how? Are we talking about billions of dollars here in profits to the discount brokers? Are we talking about the ability to gather assets in funds that would not be able to so do otherwise? What do those 12(b)1 distribution fees you see in the prospectus for distribution really amount to over time? How do they impact the long-term returns on your fund investment? This is the tsunami that is coming.

Liquid Alts: The Thrill is Gone

By Leigh Walzer

By Leigh Walzer

The tone of the 2016 Morningstar conference was decidedly subdued. Attendance was down sharply. Keynote speaker Bill McNabb of Vanguard took a “victory lap” to mark another year of rapid growth for passive funds. Active equity managers continue to get pummeled by outflows and rising distribution costs. These forces may have slowed in 2016 but the shakeout continues. Purveyors of actively managed funds are either reluctantly jumping on the ETF bandwagon or seeking defensible safe-havens like fixed-income, smart beta, and liquid alts.

Liquid Alts: Explained

Liquid alts received a lot of positive attention at the 2015 Morningstar Conference – and negative attention this year. Liquid alts are funds pursuing alternative investment strategies and offering daily liquidity. In other words, these are hedge funds marketed in “40 act” garb. Generally, investors look to alternative investments to deliver returns with below average market correlation.

Common investment strategies include Long/Short Equity, Long/Short Credit, Market Neutral, Managed Futures, Event-Driven, and Short-Selling. Fund managers can reduce risk by selling one security against another, hedging, or buying derivatives. Some are trying to deliver a market neutral return; others are trying to outperform an equity or fixed income benchmark with lower volatility. Sometimes the distinction between categories is a little blurry.

We identified a liquid alt universe of approximately 500 funds. Morningstar tracks 650 so either they use a more expansive definition or our “universe” has a few black holes. We apply two main criteria: (a) the fund describes itself or is widely categorized as an alternative strategy (b) in our assessment, it acts like an alternative fund, meaning we can’t replicate the returns using traditional strategies. We count approximately $280 billion of liquid alt assets under management.

Two thirds of these funds are single strategy, the balance are MultiStrategy. Fund of fund and sub-advisory structures are not uncommon. Some liquid alt vehicles offer investors performance which is pari passu with hedge fund classes. Others offer a separate account which may have tailored guidelines or a risk management overlay. For example, one of the fund managers we spoke to noted that he asked his subadvisors to dial down European risk before the Brexit vote. Implementation of alternative strategies in “40 Act” formats requires higher balances of cash and liquid assets – particularly for the pari passu offerings – which is a drag on returns. A few funds pay performance fees to subadvisors.

Even purveyors of these funds concede there is confusion in the marketplace about the proper role for these funds in investor portfolios. Nonetheless, the liquid alt industry has boomed over the past 8 years. The allure for investors has been access to strategies previously available only in hedge fund format. According to GSAM, Liquid Alts outperformed equity by 23% and fixed income by 16% during bear markets. The allure for fund companies has been an infusion of new assets earning higher expenses. The average expense ratio for long/short equity is 174 bps. Established managers who can raise money at 2 and 20 may not participate, but there are plenty of second-tier managers ready to step in.

The success of liquid alts has attracted a lot of new entrants. 45% of liquid alt funds are under 3 years old. (Our data for this article runs through April 30, 2016.) But the new funds have ramped slowly: only 13 % of the industry AUM are in those new funds. Growth stalled a year ago. Judging from the number of funds and the assets they attracted, the greatest interest is in Long/Short Equity and MultiStrategy funds. The biggest players in our database are BlackRock, GMO, AQR, Pimco, JPMorgan, and GSAM. Some of the industry giants like Fidelity and Cap Re have been notably absent.

Recent Results

Despite the surge of interest (or perhaps because of it) results from liquid alts have been rather disappointing. Skill as measured by FundAttribution.com for liquid alts in the aggregate has been -1% per year over the past 36 months.

Maybe the free lunch of strong and uncorrelated returns doesn’t exist after all

The biggest negatives, not surprisingly, are Short Sellers, Commodities, and Momentum. Global Macro, Credit Focused, and Absolute Return also did poorly. Event Driven and Low Volatility strategies fared best while Market Neutral, Long/Short Equity, Long/Short Credit, Currency, and MultiStrategy had a modicum of skill. These are measures of excess return corresponding to the sS measure (explained here) on the www.fundattribution.com website. (Mutual Fund Observer readers may register for a free demo. Currently, demo users can access funds in the Market Neutral and Large Value categories.)

Our sS measure adjusts the gross return of these funds for any return from equities, fixed income, commodities, or currency which we could have mathematically replicated with passive indices. Other metrics may assess skill differently. For example, alt funds (particularly Futures strategies) show slight pickup from Beta which might offset the negative skill. One way of interpreting our findings: as these strategies have gotten crowded, the performance which fueled interest has evaporated; and the cost of offsetting or hedging away risk exceeds the benefit.

Results by Strategy

Over the past 10 years, the Morningstar Market Neutral sector composite generated a return of only 0.5%. The Long/Short Equity sector, which takes more market risk, returned 1.5%. Maybe the free lunch of strong and uncorrelated returns doesn’t exist. But those sectors did show fairly good returns prior to 2006

Our take is that returns in Liquid Alts are governed by supply and demand. Just as individual managers have limited capacity, returns for the strategy suffer when too much money rushes in.

Managed Futures showed excellent returns through 2009 and poor results ever since. From what we can discern, this strategy tracks mainly commodities and currencies. While the funds are supposed to go both long and short there is a significant correlation between the category and the Barclay CTA Index. So when commodities suffer, it is hard for this strategy to work. These funds rely heavily on momentum and trend-following, a strategy which has been challenging of late.

Many hedge funds seek investments with asymmetric risk. And many strive to capture most of the market in bullish periods while declining less in a down market. However, our preliminary work suggests the major liquid alt strategies haven’t delivered on this promise. For example, using Morningstar data, the Long/Short equity category captured 41% of the upside of the S&P500 as compared with 61% of the downside.

Individual Liquid Alt Funds

Even if the market as a whole has become efficient, there is a wide range of returns among liquid alt funds. The standard deviation of sS is 3.3% for liquid alts (higher than for other asset classes we studied.) See Exhibit I. So even if sector returns disappoint, we can try and identify individual funds poised to outperform.

Exhibit I

Exhibit I

FundAttribution is a great starting point for comparing liquid alt funds. Funds in the same category may have very different correlations and factor exposures; but our metrics normalize the impact to permit clean comparisons. Even the drag from holding extra liquidity can be isolated.

For example, AQR Managed Futures Strategy (AQMIX) returned roughly 3.6% (4.7% gross return) on an annualized basis from inception through 3/31/16. We estimate that without directional bets on commodities and currency, that return would have declined to 2.6%. That return is fully explained by the fund’s exposure to credits markets. So we don’t ascribe any skill to the manager.

Here are some funds which show well. Some had strong sS over the past 3 years in relation to expense ratio. Others have done well over a longer period. Not all of these made the Trapezoid Honor Roll (implying 60% confidence that next year’s net return will be positive.) Some don’t have enough track record and others are too small.

Exhibit II

Exhibit II

One Honor Roll fund is Vanguard Market Neutral Fund (VMNIX). The fund has been around since 1998, costs are very low. (The minimum investment is $250k.) Around 2007 Vanguard replaced the subadvisor with its own Quantitative Equity Group; since then sS has been exceptional. Most of the return is based on buying stocks cheap using fundamental analysis and selling expensive stocks in the same sectors. The investment process is systematic but human judgement plays an important role. The strategy has grown from $0.3 billion to $1.7 billion over the past 18 months but there appears to be plenty of remaining capacity. Much of that growth has been through Schwab. We also observed an independently managed liquid alt parking its excess cash in VMNIX. Investors who register for the demo can access additional analysis of VMNIX and other Market Neutral funds at www.fundattribution.com.

The eight largest liquid alts in our universe registered negative sS over the past 3 years. One large player which has performed well is Boston Partners Long/Short Research Fund (BPIRX). Historically, net exposure has been 40 to 60%. BPIRX is closed to new investors. Boston Partners Global Long Short Research Fund (BGLSX) is currently open. We do not publish metrics on BGLSX because the management team has been on the job less than three years.

Event Driven has been one of the stronger liquid alt categories in recent years. For investors who want exposure, IQ Merger Arbitrage ETF (MNA) is a passive ETF managed by NY Life. which goes long announced deals and hedges out market risk by shorting equity indices. The event-driven category encompasses many strategies; this is one of the more vanilla. Demand in this category has been relatively stable which may have aided returns while supply (M&A volume) was robust. But M&A activity may be poised to fall.

New SEC Rules

The rapid expansion in liquid alts has not gone unnoticed by regulators. The SEC has moved recently to regulate use of derivatives by mutual funds, which it views as a form of leverage. A draft rule 18f-4 was circulated December 2015 and industry comments were submitted in March. An industry association estimates that funds managing $600 billion would be impacted by the rule. One of the nettlesome provisions would regulate leverage based on the gross notional value of derivative positions. A coalition led by AQR and John Hancock seeks to modify the rule. They note some asset classes like currencies and futures can sustain higher leverage. Among other things they want the limitations to reflect the value at risk, relax requirements to post cash, and give greater leeway if a fund temporarily exceeds the ratio. We also observe that funds like AQMIX have many offsetting risk positions. So while we share the SEC’s overall concern, their starting position seems extreme.

Takeaways

Everyone is taking potshots at hedge funds these days, that extends to liquid alts in “40- act wrap.” The growth phase is largely over; a few funds have closed. It will be interesting to see how much the SEC rules are relaxed and how fund structures hold up during periods of volatility.

We do find some funds which delivered in the past. We would not be quite so generous as Morningstar in awarding 4 or 5 stars, because the statistical significance of their short track records is simply too low.

Even if investors can identify skilled managers, they need to consider the timeliness of the strategies and monitor how quickly they gather assets. Opportunities (supply) in these markets come and go, demand is not always in synch. You can either skate to where the puck is going or be patient and diversify.

Slogo 2What’s the Trapezoid story? Leigh Walzer has over 25 years of experience in the investment management industry as a portfolio manager and investment analyst. He’s worked with and for some frighteningly good folks. He holds an A.B. in Statistics from Princeton University and an M.B.A. from Harvard University. Leigh is the CEO and founder of Trapezoid, LLC, as well as the creator of the Orthogonal Attribution Engine. The Orthogonal Attribution Engine isolates the skill delivered by fund managers in excess of what is available through investable passive alternatives and other indices. The system aspires to, and already shows encouraging signs of, a fair degree of predictive validity.

The stuff Leigh shares here reflects the richness of the analytics available on his site and through Trapezoid’s services. If you’re an independent RIA or an individual investor who need serious data to make serious decisions, Leigh offers something no one else comes close to. More complete information can be found at www.fundattribution.com. MFO readers can sign up for a free demo.

Morningstar Conference: Grasping at Straws, Department of Labor’s Fiduciary Rule, and Vanguard CEO McNabb

By Charles Boccadoro

During our annual (sometimes bi-annual) excursion to Chicago this past month, I was reminded of the old adage:

“We see things not as they are but as we are–that is, we see the world not as it is, but as molded by the individual peculiarities of our minds.”

Quickly followed by:

“It’s better to be uninformed than misinformed.”

morningstar_1

Company President Kunal Kapoor started the first day general session by showing Morningstar’s Market Fair Value metric … “It says the US market is fair valued.”

Gold-star fund manager Michael Hasenstab of Templeton Global Bond (TPINX) stated that “we are at a pretty rare point in markets where you have huge dislocations … unprecedented and untested monetary policy experiments creating tremendous amount of volatility.” The Fed will inevitably be raising rates, due to inflation and a labor market with little or no excess capacity. He is negative US Treasuries (“valuations nowhere near justified”), but sees “real upside opportunities in select emerging markets … the most unloved asset class.”

Later the same day, famed author and investing advisor Bill Bernstein stated that “I do find foreign equities valuations more attractive. Of course, there is good reason for that. Stocks don’t get cheap without good reason.”

The day two general session featured a polite debate called “Meeting of the (Big) Minds: Arnott and Asness.” Mr. Arnott’s firm Research Affiliates maintains an Asset Allocation site that provides 10-year Expected Returns across various securities and asset classes. The bottom-line: near zero real return expected for traditional asset classes. “Valuations matter,” he explains. He sides with Professor Shiller that US equities based on historical norms are currently overvalued.

morningstar_2

During a sidebar with Tadas Viskanta, founder and editor of Abnormal Returns, he offered his impression of the conference: “Grasping at straws…”

Our colleague Ed Studzinski later added: “Half the people in this room will not be here five years from now.”

How many people were there? 2016, including 831 paid advisors, 581 exhibitors, and 43 speakers.

morningstar_3

Why might Ed think the attendance will be under pressure? I’ll offer two reasons: The Department of Labor’s (DOL’s) Fiduciary Rule and Vanguard; basically, the two elephants at the conference.

As background, please reference:

  • Fact Sheet – DOL Finalizes Rule To Address Conflicts of Interest In Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year.
  • “Why Vanguard Will Take Over the World,” by our colleague Sam Lee from October 2015 commentary.

The new fiduciary rule requires investment professionals, consultants, brokers, insurance agents and other advisers “to abide by a fiduciary standard—putting their clients’ best interest before their own profits.”

Patrick Clary, Chief Compliance Officer at AlphaArchitect (former USMC Captain, a Harvard MBA, ops/complinance ninja) puts the meaning of fiduciary in proper perspective in the insightful March 2015 post “Distribution Economics – Understanding Wall Street’s Conflict of Interest Problem”:

Fiduciary responsibility matters in financial services more than in any other product category outside of urgent medical care. Shouldn’t this fiduciary have your best interests at heart? Just as you don’t want your doctor to receive kickbacks from Pfizer for overdosing you on Oxycodone, why would you want your financial advisor–or their institution–to receive kickbacks for overdosing you on inefficient, overpriced, investment product that probably won’t help you achieve your investment goals?

HBO’s John Oliver recently gave a more humorous but no less accurate account (click on image to play YouTube video):

morningstar_4

In the same session where Bill Bernstein spoke, Morningstar’s Don Phillips warned the fiduciary rule will usher in an “era of blame … litigation heaven.” And in fact, several groups have filed suit against implementation, which is scheduled to become effective initially April 2017, with final compliance required by 1 January 2018.

During the conference break-out session “The Fiduciary Rule and the Future of the Industry,” analyst Michael Wong presented an assessment of impact of rule on financial industry:

morningstar_5

He predicts three main trends:

  • The movement to fee-based from commission-based full-service wealth management accounts.
  • Adoption of robo-advisors and digital advice solutions.
  • Shift to relatively lower-cost passive investment products from actively managed.

Morningstar was kind enough to share the session’s presentation charts, here.

Here is a telling example of landscape investors face today. Lipper identifies 42 funds in the category “S&P500 Index,” oldest share class only, at least three months old, as of May 2015. The expense ratios range from less than 20 basis points for funds offered by Vanguard, State Street, Schwab, Northern Funds, Fidelity, Blackrock, and DFA to nearly 60 basis points and higher for funds offered by Legg Mason, Great-West, and Nuveen.

Hard to see how any advisor “acting as a fiduciary” could recommend the funds with the substantially higher expense ratios.

Lipper shows 693 US large cap equity funds, but exclude the S&P Index and other index funds, the number is 532. There are more actively managed large-cap funds than stocks traded in the S&P500! Some industry experts believe the fiduciary rule will help flush out “closet indexers.”

Similarly, Lipper shows 2,447 US Equity funds, which is nearly as many funds as there are equities in the Russell 3000 Index, representing 98% of the US public equity market. How can that be? David is fond of enlightening us: “… 80% of all funds, active and passive, could vanish without any loss to anyone other than their sponsors.”

Maybe Ed has underestimated.

Michael Wong reports: “We’ve already seen the exit of several foreign banks (Barclays, Credit Suisse, Deutsche Bank) from the U.S. wealth management landscape, sale of life insurance retail advisory businesses (AIG, MetLife), and restructuring of wealth management platforms (LPL Financial, RCS Capital, Waddell & Reed) in anticipation of the rule.”

At the same session, Morningstar Australia’s Anthony Serhan stated that the rule, which effectively imposes “fiduciary” criteria in place of “suitability” criteria currently practiced, will help force brokers and fund companies to unbundle their proprietary products from financial advice. The rule will bring more transparency … like turning on a light in a dark room. Serhan warns: “Put decent value on table or be challenged.”

One fund manager speculated that brokers will likely switch to using Morningstar ratings instead of their own “Select Lists” or “Preferred Lists” currently practiced.

On day three general session, Vanguard CEO Bill McNabb encouraged advisors not put off implementation of DOL’s fiduciary rule because of current lawsuits … will take 12-18 months to implement required processes so “prepare as if court cases will not be successful.”

morningstar_6_cr

The new fiduciary rule will only help to advance Vanguard’s already dominant position. Of the 9,360 US mutual funds through May, excluding money market and funds less than 3 months old, Vanguard has five of the top six funds by assets under management (AUM):

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It has 36 funds in the top 100. It has $3.4T in AUM. Our MFO Fund Family Scorecard shows 76% of Vanguard’s 164 funds have beaten their peers since inception.

Its fees are amongst the lowest in industry. Its robo-advisor, Vanguard Personal Advisor Services VPAS, has quickly gained $40B in AUM mostly from existing Vanguard customers.

Mr. McNabb stated VPAS targets accounts between $50 – 200K and charges 30 bps points versus the 1% charged by most advisors. His advice to other advisors: “Go lower, or do more.”

Going forward McNabb’s vision for Vanguard in 2026 “will be a far more global firm … where we really run all of our investments on a global basis.” Only $300B of its AUM is from non-US clients. He sees tremendous demand for Vanguard products globally and meeting that demand will be “the most profound change in Vanguard over the next decade.”

On the product side, he sees making more tools available to advisor community, particularly to help manage the “drawdown phase” facing retired baby boomers. And also sees simplification of services … vibrant applications for mobile and a move away from PC-based tools.

While enjoying deep dish pizza after the conference at the famed Giordano’s and then stroll afterward to walk it off up Michigan Avenue to Chicago’s magnificent Millennium Park, our colleague Sam Lee pondered that scandal would be the only threat to Vanguard’s continued dominance.

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Meb Faber Podcast

By Charles Boccadoro

mebfaber_podcast

Meb recently debuted his new podcast about investing with the same casual, refreshing, and insightful perspective we’ve come to respect and appreciate, since first profiling him in May 2014 with The Existential Pleasures of Engineering Beta.  

The podcast is definitely worth tuning into. The first five episodes are now on iTunes, available for free. You can subscribe here. They are:

  1. Global Asset Allocation – Investing 101
  2. Patrick O’Shaughnessy – An Unexpected Drop-in from Patrick O’Shaughnessy
  3. Jeff Remsburg – Where Are the Best Global Values Right Now?
  4. Wes Gray – “Even God Would Get Fired as an Active Investor”
  5. EJared Dillian – “If You Think 2016 is the Opposite of 1981, then You Should Do the Opposite”

Material referenced during the podcast is nicely provided on Meb’s website, like here from Episode 1.