Two Roads: 1 to N, 0 to 1
“Doing what we already know how to do takes the world from 1 to n, adding more of something familiar. But every time we create something new, we go from 0 to 1. The act of creation is singular, as is the moment of creation, and the result is something fresh and strange.” – Peter Thiel, Zero to One
Two roads diverged: one taking you from 1 to n and the other from 0 to 1.
On which path is the asset management industry headed?
If we’re being honest, the answer is clear. It’s on the road from 1 to n and has been for some time now. Technology and intense competition are driving down fees at an accelerating pace. There is no sign of this trend abating anytime soon and no economic rationale why it should. If this continues, we will eventually reach a state of “perfect competition,” where in the long run no company makes an economic profit. From Thiel:
“’Perfect competition’ is considered both the ideal and the default state in Economics 101. So-called perfectly competitive markets achieve equilibrium when producer supply meets consumer demand. Every firm in a competitive market is undifferentiated and sells the same homogeneous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down, and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they’ll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit.”
Vanguard may be perfectly happy in such a world, but most other firms will not be. They will leave to find an industry where they can actually make money, supply will come down, and only then will prices stabilize. With over 10,000 hedge funds currently managing a record $3 trillion at high fee levels, however, we are a long way from such a world. And with hedge funds underperforming by a wide margin over the past 10+ years now (see here and here), there is every reason to believe that we are still in the early stages of such a transition.
While the massive shift from active to passive may ebb and flow in years to come, the underlying force (technology and competition) will remain. Unless technological advances slow (not likely) and competition abates (we are a long way from that), fees will have to come down to the point where active managers earn their keep.
But what about the active managers who have been screaming about “peak passive” for years now, yearning for a return to yesteryear when they could make outsized profits while adding little or no value. “Just wait for the next bear market,” they say, “you’ll see all those mindless passive investors come running back.”
The only problem with this logic is that there is no evidence to support their supposition that active has delivered superior performance relative to a benchmark during bear markets. While some active strategies will outperform (just as some will outperform in a bull market), it is a myth to say that active managers collectively have demonstrated any unique ability to navigate bear markets.
If you are in the active business already, do you just sit back and accept it? Some will and others will attempt to compete on price, a dangerous game given how low the Vanguards and the Schwabs of the world are willing to go.
But is there any other answer to the seemingly inevitable commoditization of the business?
I believe there is, but it is not an easy path and it is not for most. You will have take the road from 0 to 1, creating something new.
By “new” I do not mean slicing the market up into forever smaller segments while charging a higher fee than comparable passive products. This can work in the short run if you’re lucky, but is not a sustainable competitive advantage over time. Your “monopoly profits” will eventually disappear.
The cyber security ETF (HACK) is one recent example. Launched in November 2014, it rocketed to $1.4 billion in assets by July 2015, one of the “fastest ascents in ETF history.” Returns versus the S&P 500 were stunning (21.7% vs. 4.7% through July 31, 2015) and investors did what they do best: chase past performance.
By August 25, 2015, assets were down to $1.2 billion after a sharp decline in performance. But the Bloomberg story was already in motion, reveling in the success story of the 30-year old founder: “The one-man, $1.2 billion ETF Shop.”
“With fees of 75 basis points and an asset base of $1.2 billion, HACK stands to toll off fees of $9 million a year.”
You can guess by the path of the chart above what happened next. As performance continued to wane, assets flowed out. HACK still manages an impressive $750 million, but for how long it can maintain those assets will depend on more than just performance. For they now have a close competitor, First Trust, which launched its own cyber security ETF (First Trust Nasdaq Cybersecurity ETF, CIBR) in July 2015, when assets in HACK reached their peak. CIBR’s expense ratio, while still relatively high at 0.60%, is 15 bps cheaper than HACK. CIBR has thus far attracted $137 million in assets.
If HACK’s assets remain high, we should expect more entrants to the space at even lower fees, until economic profits go to zero. That is the nature of a business without a competitive advantage and minimal barriers to entry. HACK might have a “first-mover” advantage and name recognition, but there is nothing unique about its offering that cannot be replicated at a lower fee.
That is not to say it won’t continue to earn profits for some time. Investors can be lazy and irrational for longer than you think. Remarkably, the Solar ETF (TAN) still has $171 million in assets charging 0.71% in fees even though it has woefully underperformed the S&P 500 since inception in 2008. There is apparently a solar fan base large enough that they are happy to pay a premium price for a commoditized product.
This may be true in cyber security as well, but these are exceptions, not the rule. Far more products will fail due to their commoditized nature than succeed. A new ETF rolls out, on average, every single business day. More supply is on the way and simple economics dictates what that will do to price.
The lesson to be learned by the successes of products that take the world from 1 to n? Sometimes you get lucky. The timing of HACK was perfect as it benefited from a few high-profile cyber attacks (Sony and Anthem) and an early hot streak in performance. That is not a repeatable process as evidenced by another offering from the same creator of HACK, the Big Data ETF (Ticker: BIGD), which has attracted just $2 million in assets since its inception in July 2015.
The road from 0 to 1
There is only one lasting alternative to creating something the world has already seen. Create something that is truly different. As I noted above, though, this isn’t an easy path, particularly in the asset management business. It is the much harder choice.
Because something that is truly different than what exists today will have a large deviation from the standard industry benchmarks. Most active managers hug their benchmarks closely for a reason: investors have a very low tolerance for anything that deviates from the norm on the downside. When I say low tolerance I mean they will start redeeming if there is a 6-12 month period of underperformance, and if there is anything longer the floodgates will open.
Therein lies the problem, because even the best strategies will have many, many periods of underperformance over 1 to 3 year time periods. And if those periods of underperformance happen to come early in the life of a fund/strategy, it may not live to see the other side.
But it is a problem and risk that is unavoidable if you want to go from 0 to 1. For in order to have a chance of beating the market average, you have to look different than the average. And looking different means there will be times when the market average looks great and you look terrible. There is no other way.
What does that mean in practice for active investors?
- The Vanguard Value ETFs (VTV – Large, VBR – Small) have an expense ratio of .08%. If you are a large/small value manager charging premium fees, you will need to beat these funds after expenses in order to compete in the new world order. The only way to do that is to look different.
- The iShares MSCI USA Momentum Factor ETF (MTUM) has an expense ratio of .15%. If you are a momentum manager charging premium fees, you will need to beat this fund after expenses in order to compete. The only way to do that is to look different.
- The newly issued Deutsche X-trackers USD High Yield Corporate Bond ETF (HYLB) has an expense ratio of 0.25%, half of the leading ETF in the space (HYG). If you are a high yield bond manager charging premium fees, you will need to beat this fund after expenses in order to compete. The only way to do that: look different.
In looking different, you still might not beat these passive products (the odds are stacked against you as any academic study will tell you), but at least you have a fighting chance. The active managers that hug their benchmarks and charge premium fees have no chance. The passive managers slicing and dicing passive indices, fighting each other to the death for basis points, will eventually drive economic profits in that space to nothing.
From 1 to n or from 0 to 1?
The choice is yours.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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