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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.

Don’t count on it

Yesterday a poster asked where to park $400,000 for a year. It’s got to be insured, he said. And so others told him about CDIC – the Canada Deposit Insurance Corporation – and the limits it places on guaranteed investments. Too bad it’s bunk. In reality, in Canada, there’s no insurance against a big bank failing, and taking your money along with it.

Sure, I know all about the CDIC rules. The federal agency tells you it’ll insure deposits of up to $100,000, per account holder, per bank. So, a couple might think they have insurance of $300,000, a hundred for each and other hundred for a joint account. In fact, I’m constantly amazed at the people I run into who have meticulously doled out their nestegg among five or six banks, to ensure their money is ‘fully guaranteed.’

It’s also interesting how many people think this insurance extends to everything they buy through investment dealers and brokerages owned by the banks – outfits like CIBC Wood Gundy or TD Waterhouse. Of course, it does not. And unknown  numbers of Canadians also believe all the products they get at banks are insured, while the same products bought at non-banks, like Investor’s Group or Manulife, aren’t.

For the record, deposit insurance only applies to deposits, wherever they are. That includes savings accounts, term deposits and GICs. Yeah, the stuff that pays you less than inflation to own it, with a negative rate of return. Not covered are the other major product banks flog, mutual funds.

But all this is largely irrelevant, since deposit insurance for our Big Six is illusory.

As you may remember, during the financial crisis of three years ago, there were runs on banks. In the US, Indymac was emptied by freaked-out depositors (and failed), and in the UK, people lined up for hours desperately trying to get their cash out of Northern Rock. Both banks were ultimately taken over by federal authorities, who also moved to goose deposit insurance and stem public panic.

It worked. Along with massive injections of cash into the banking system, confidence was restored. But the cost was gargantuan. Even in Canada, the feds quietly spent the better part of $100 billion buying mortgage portfolios from our banks, to ensure they were flush with cash. Taxpayer cash. But unlike in the States and elsewhere, deposit insurance here was left at $100,000.

So, why do I say it’s illusory?

Well, let’s look at our largest bank, the Royal. It’s a massive corporation and, by all accounts, superbly run. It makes a pile of dough and shares it generously with stockholders.

Among RBC’s liabilities is $161 billion in personal deposits, held mostly by individual Canadians. And how much actual cash does the bank have (according to its annual report)? Just over $9 billion (and some of that is loaned out to other banks at any one time).

So in the unlikely instance the bank had to suspend operations or actually failed, there would be a shortfall of at least $150 billion payable to depositors. And that’s where CDIC comes charging in on its white horse. Sort of. Problem is, CDIC apparently has only $2.1 billion in assets. So that leaves RBC customers short about $148 billion. But that is more than half of the entire federal government’s budget, which means the country would have to be shut down (including education and health care) to look after the depositors of one bank.

Sadly, though, if the Royal tanked, you can bet two or three of the other guys would as well – so you see the problem? There’s not enough cash in the banks or present within in the government to pay depositors if one of the Big Six folded.

So how does this work in the US, for example, where deposit insurance is $250,000 per account?

Well, they don’t have just six. There are 9,459 American banks with deposits of $100 million or more. Of those, only 22 have deposits of more than $50 billion. So the odds of getting your money back if the Second National Bank of The Adirondacks tanked are pretty damn good. With CIBC, not so much.

Am I saying our banks are at risk?

No. They’re not. And you won’t in your lifetime be reading about the failure of Royal, BMO, Scotia, TD, CIBC or National. If any one of these guys went down, you’d better have lots of ammo and canned squirrel.

But parceling money up and shipping it around between banks, in deposit instruments which guarantee you’re backsliding, just because you think this is a safe strategy, is actually augmenting risk. You’d be far better buying shares in these banks, or their bonds, or their preferreds because you’d be munching on their profits.

And your rate of return wouldn’t be less than zero.