Among the costs of actively managed mutual funds often cited
by critics such as John Bogle is the hidden cost of “market impact”. Market
impact is the change in market price created when a large mutual fund decides
to liquidate or initiate a position in a particular stock. Depending on the
size of the trade and the particular stock the active fund manager can find
that as he buys (sells) stock he pushes the price up (down) increasing the
impact on the funds returns.
Portfolios made up of ETFs were thought to alleviate this
problem. Trades were to be infrequent and when the trades were exercised in
relatively small amounts by individual investors the impact would be small.
However the growth of large “managed ETF programs” and “robo advisors” may mean
that the “slippage factor” may have returned through these programs reducing
the returns for investors in these programs.
Managed ETF programs have grown tremendously over recent years as brokers and investment advisors “outsource” the management of ETF portfolios to large managers. The strategies and frequency of the trading varies. But observers have already noted that the large trades can have significant impact on market prices. The impact can be further aggravated because some of these managers both manage accounts directly and issue “buy and sell alerts” which individual advisors and large brokerage firms implement on their own. Thus not only are there trades directly from the advisor entering the market but trades from other sources making the same buy/sells as well. The result when the orders hit the market is that the trades can move the market creating the same ‘slippage” as active stock manager’s experience. For the client that means an unseen cost.
An article by Matt Hougan in ETF.com focuses on the large flow created by some of these managers although it doesn’t specifically reference the slippage article. He writes that through use of the fund flow data on the etf.com website it is possible to isolate ETF activity that generates one time large trade flows and those that represent a trend in flows in and out of an asset class. He notes that often there are large flows in a particular ETF even though similar flows may not be present in other ETFs in an asset class.
He offers the example of large one day flows in three US
treasury etfs, His explanation:
The
fact that all those flows occurred on one day suggests that a single large
investor made these decisions, as opposed to "investors" in general.
In fact, we can probably even guess which investor made these bets: Good
Harbor Financial.
Good
Harbor is a large, well-run ETF strategist firm with $10 billion invested in
quant-driven ETF strategies. It rebalances its portfolios twice a month—once on
the 15th and once at the end of the month—which coincides
perfectly with the timing of these flows (due to settlement delays, fund flows
don't always appear the day an investor buys a fund).
What
we're seeing in the flows for IEF, SHY and IEI is Good Harbor getting nervous,
not the market in general. That's a worthwhile signal—Good Harbor has a great
track record—but it's just one opinion. And in fact, a quick glance at this
morning's preliminary flows numbers suggest big outflows in both SHY and IEI,
two of the Good Harbor targets in question.
I have no idea whether Good Harbor is a well-run strategist
with a good track record or not. I do know that by looking at the flows from
their trades and the market behavior on those days it is clear that their
trading has a market impact. It also seems quite possible that if an analyst
like Mr. Hougan knows the dates of the rebalancing then so do some market
participants who may try to profit from that information to the detriment of
Good Harbor. The examples in his articels are from Etfs in US Treasuries which have large
numbers of assets, large daily volume, and good liquidity, yet the trades by
this one manager clearly have impact on the market in those ETFs. It would only
be reasonable to assume such impact would be even greater in the case of other
less liquid ETFs.
The charts of the one
month flows from etf.com are below. Below each graph I have put a price/volume graph
(2 months) of the same ETF. In all three cases there was an increase in the
day’s trading range--.an indicator of market volatility—relative to other
trading days. In fact there are other large trading range days that also occur
on the 1st and 15th of the month the rebalancing dates for
Good Harbor.
.
Here's
the chart for IEF in August fund flows for August and below it price/volume for July and August
And here is the same data for SHY
And here for IEI
Good
Harbor is only one of a number of large managed ETF portfolio managers. Many
market participants have noted that their trades can have significant intraday
market impact which may be a drag on returns. As the assets under management of
these managers grows the impact is likely to increase. Furthermore there is a
rapid growth in robadvisors internet based portfolio management with
allocations that are rebalanced at fixed dates. As these grow there is more
potential for increasing the number of large trades that create volatility and
perhaps distort prices for brief periods
What
are the implications for individual investors? That is the subject of my next
blog on the subject.
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