Entries from February 2018 ↓

Don’t go quietly

DOUG By Guest Blogger Doug Rowat

Remember Dr. David Dao?

Here’s a refresher:

Thankfully, Dr. Dao was awarded an undisclosed, but likely substantial, settlement from United Airlines and two of the security officers involved in the incident were fired.

Remarkably, however, another culprit was indirectly blamed for the debacle: ETFs. How so? Well, the logic goes something like this: the US airline sector has a massive amount of passive, institutional ownership (Vanguard being a prime example), which has contributed to a dramatic decline in competition amongst carriers and therefore to a corresponding spike in passenger fares and decline in passenger care and service.

Poor passive ETFs. They’re just quietly going about their business outperforming active managers and all they get for their trouble is a metaphorical beating and drag down the aisle.

The overall argument against passive ETF investing is actually sound. The New Yorker sums it up best:

[With passive investing] investment decisions are increasingly on autopilot: more and more money will pour into a set of firms largely independent of the considerations that have traditionally guided investors, such as supply, demand, management performance, growth potential, or broader economic factors.

A market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not.

Agreed. The investing world actually needs active management. Active management is required to punish those companies that are operating poorly. It’s needed to prevent a valuable company from perpetually remaining valuable. Security pricing must be a gauge of a firm’s underlying prospects. If it isn’t, then asset bubbles will form, particularly amongst larger companies, and smaller firms that are deserving of capital, and likely need it more, will be denied.

However, the problem with this argument is that the investment industry is still dominated by active management. In other words, the problem is—and likely will remain so for decades—only a theoretical one.

No one is arguing that the ETF industry isn’t growing faster than the mutual fund industry. It’s winning this race by a long shot. According to the Investment Company Institute, from 2012 to 2016 the US mutual fund industry grew by 25% whereas the ETF industry grew by almost 90%. However, the ETF industry is coming from so far behind that it’s not even close to rivalling the mutual fund industry in overall size. Unfortunately, the 2017 data from ICI probably won’t be available until April, but the data from 2012 to 2016 still paints a clear picture: ETFs may be growing faster, but they significantly lag mutual funds in overall assets. As a ratio, mutual funds ‘outsize’ ETFs by 6.5:1, or by almost US$14 trillion (with a ‘t’).

US ETF Industry is Growing, but is Still Dwarfed by Mutual Funds

Source: Investment Company Institute

Further, within the ETF industry itself, there is a significant shift towards active management. No one is making any money charging 6 or 7 basis points to passively track an underlying index. The ETF industry is realizing that it needs to offer more and therefore charge more. This is one reason why so many mutual fund companies are now issuing ETFs: they want to capitalize on the sector’s growth, but also want to leverage their active management roots in order to charge more. The Canadian ETF space, for example, is now almost 30% actively managed, according to Bloomberg data, and these actively managed ETFs charge, on average, 33% more than passive ETFs.

Naturally, the attacks on passive ETFs are primarily coming from active managers. As is common knowledge at this point, actively managed mutual funds almost always underperform their benchmarks with high fees being the main reason. According to the latest SPIVA US Scorecard, about 90% of US large-cap fund managers have underperformed their benchmarks over the past 15 years. So, poorly performing and expensive active managers still need to be purged from the system. And it certainly strikes me as easier to discredit ETFs by focusing on the theoretical consequences of passive investing at some point in the distant future rather than addressing the clear, and already present, problems within the actively managed mutual fund industry.

And ask United Airlines how well the discredit-through-misrepresentation tactic works. Recall that United Airlines CEO Oscar Munoz initially tried to imply that Dr. Dao was primarily responsible for his own broken, bloody face because he “defied” security officers. Not well played.

The public, like investors, eventually sees the truth.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.


Freshly-showered and fumigated after moderating yesterday’s comments section, let’s try this again.

To summarize: government isn’t the answer. Politicians helped fuel the housing bubble. Now they clumsily crush homeowners. Better that Mr. Market were left on his own to keel over from rising rates and an ocean of debt. Instead, elected amateurs in Ontario and (especially) BC have opted to tax everything that moves (Chinese dudes, cowboys, cottage owners, the doctor class) and hope for the best. With the economy now so dependent on real estate and the bulk of middle-class net worth sitting in it, the stakes are huge. As stated yesterday, the outcome could be Biblical. And not in the angelic way.

Anyway, it’s time for a counterpoint to all those whiny, lefty moisters who feel entitled to a house and demand that the government make it happen. So, here’s George.

I greatly enjoy your blog, but I’m hoping you can help me understand a trend that I can’t quite grasp.  On your blog, I’m seeing constant complaints such as:

“It’s downright tragic”
“…being shut out by a bunch of greedy a-holes is a bitter thing…”
“…people cannot afford kids…”
“Move out while you still have a chance, i.e. young and with a future…”

Your advice recently has been “move, or shut up,” an understandable response, but I genuinely do not understand why people seem so desperate. I’m 25, married, have 2 kids, and make $79k (single income). No debt. Our rent is $1800 a month for a cozy Markham townhouse that we love. We own a used minivan and are comfortably socking away $10,000 per year, minimum. My wife stays at home with the kids, so we only need one vehicle and don’t need to pay for daycare. My work commute is 10 minutes, and we live close to family and friends. Life, for us, is wonderful.

So why does everybody else seem so miserable? My theory is that people (especially my age) are making bad life choices and choosing to blame others for their misery, or am I simply living beyond my means? Thanks! – George”

Apparently normal people do read this pathetic blog. Who knew?

Well, here’s more evidence why the housing market in BC (and Ontario, Alberta and most major markets) is destined to roll over, even without the heavy and misguided hand of socialist MPPs. Stock markets have now embraced the reality of rising interest rates. Despite swelling bond yields, investors have turned their focus to romping and robust corporate profits, strong (US) job creation, an easing of world nuclear tensions, business tax cuts and a hefty rise in global growth.

So what? So the Fed will increase its key rate three times this year, adding to the four hikes we got in the last year. The Bank of Canada absolutely will follow suit, with the usual lag. Count on three more increases here in the next 12 months, taking the bank prime to 4.25%. The benchmark Bank of Canada five-year mortgage will sit at just below 6% then, with mortgage borrowers having to qualify at that level or higher.

That’s a big deal. Huge. On its own, more than enough to turn a busy real estate market into a stagnant one. Add in record levels of household debt, half of it facing refinancing in the coming months – with the stress test in place – and the market goes into reverse. The hallowed soft landing. Now add in a 15% or 20% go-home tax in BC and Ontario, that massive ‘speculation’ tax creaming off $200 million from existing homeowners, the empty-houses tax, the luxury tax, the universal rent controls, the enhanced property tax and maybe (if Van’s crazy mayor gets his way) a flipping tax, and we’re begging for a crash.

As the loopy comments section demonstrated yesterday, many people crave this. They think real estate – which accounts for more of Canada’s economy than oil & gas and a full quarter of BC’s GDP – can be leveled and everything will stay the same. Except they can buy a house from some decimated rich guy for 50% off. Torches and pitchforks swarming over the castle moat.

You must feel pity for those who support the NDP’s tax-tax budget, believing the politically-induced houseageddon will let them move up to a bigger, nicer place. Don’t they understand their own home would be sliced in value, putting them in the same spot? If the economy sputters, surely jobs will be shed, wages reduced, employers impacted and families hit. And if this happens, as mentioned, when central banks are tightening monetary policy it exacerbates all.

Well, maybe this is drama queen talk. Laissez-faire, right-wing, free enterprise, rugged individual, capitalist fearmongering. Perhaps Comrade Horgan and the Dippers are economic geniuses who can accomplish what no prior administration has – make people wealthier by taxing them poorer. Let’s see.

This much is clear, though. Expectations are epic. People want gain without consequences. Loaves and fishes.

If BC were a stock, I’d short it.