There has been abnormal changes in fund positioning in recent months, in financials and real estate, consumer, and energy and materials:
- Financials and Real Estate: With the sector expected to benefit from tax reform and deregulation, Financials have emerged from a 15-month long underweight in 2017 to hit the benchmark (S&P 500) weight, driven by Banks and Capital Markets. Broken out from Financials as its own sector in 2016, Real Estate saw the biggest increase in exposure across sectors in 2017, with its relative weight rising from .33x a year ago to .40x today — the highest level in our data history since 2009.
- Consumer: PMs cut back on Discretionary and Staples exposure throughout 2017, with relative weight in Discretionary today at an 18-month low and Staples at its lowest level since 2009.
- Energy and Materials: These two sectors saw the biggest drop in relative weight last year as managers continued to shun commodity exposure. The relative weight in Energy has dropped from .87x a year ago to .76x (although is neutral on a beta adjusted basis); and Materials dropped from .95x to .86x today, its lowest level since 2009.
Looking at the hard economic impact of the Great Depression (1929-1932) and the Great Recession (2007-2009), leads us to the eminent role played by banks in both. It then comes as little surprise that the banking sector captures all the attention. However, what remains to be looked into, and perhaps more worrying in today’s environment, is the role of prolonged periods of uptrend and low-vol on the asset management industry. This is where the risk builds…as everybody gets overly comfortable and ultimately concentrates in the same investments.
In 2014, the Financial Stability Board (FSB), an international body that makes recommendations to G20 nations on financial risks, published a consultation paper asking whether fund managers might need to be designated as “global systemically important financial institution” or G-SIFI, a step that would involve greater regulation and oversight. It did not result in much, as the industry lobbied in protest, emphasizing the difference between the levered balance sheet of a bank and the business of funds.
The reason for asking the question is evident: (i) sheer size, as the AM industry ballooned in the last few years, to now represent over 15trn for just the top 5 US players!, (ii) funds have partially substituted banks in certain market-making activities, as banks dialed back their participation in response to tighter regulation and (iii) , funds can indeed do damage: think of LTCM in 1998, the fatal bailout of two Real Estate funds by Bear Stearns in 2007, the money market funds ‘breaking the buck’ in 2008 amongst others.
But it is not just sheer size that matters for asset managers. What may worry more is the positive feedback loops discussed above and the resulting concentration of bets in one single global pot, life-dependent on infinite momentum/trend and ever-falling volatility. Positive feedback loops are the link for the sheer size of the AM industry to become systemically relevant. Today more than ever, they morph market risks in systemic risks.
Volatility will not forever be low, the trend will not forever go: how bad a damage when it stops? As macro prudential policy is not the art of “whether or not it will happen” but of “what happens if”, it is hard not to see this as a blind spot for policymakers nowadays.
Generally speaking, large positive net flows lead to higher prices. But the presence of these flows is only possible due to the way ETFs are constructed. As explained here:
ETF shares are created when an “authorized participant” deposits a daily “creation basket” (or cash) with the ETF.
ETF shares may be redeemed through the reverse of the creation process. That is, an authorized participant presents the specified number of ETF shares to the ETF in exchange for a “redemption basket” of securities, cash, or both, which typically mirrors the creation basket.
This creation and redemption creates traceable flows, but this process is not repeated in other instruments such as Bitcoin. There are some Bitcoin ETFs planned, but even when we have flow data for them, the flow data does not always correlate to price.