I may be chicken little and think the sky is falling, but it
is unclear what my financial analysis skillset in will get me in the future,
especially the long run.
Financial professionals often tout the power of free markets.
They speak highly about creative destruction and speak with ease about re-training
programs for those left behind. However, they, including me, may get a taste of
their own medicine. Challenges from passive investing may render the
traditional finance skillset useless and anachronistic for many. Either ETFs
cools down or I am dead.
It came fast and furious, passive investing through ETFs
will account for about 50% of all assets under management by 2017-year end. As
more people put their money into ETFs, fewer people are putting their money in
mutual funds and hedge funds. So far, there is a good reason for this. Since QE
started in 2008, the broad market has been performing very well. While good
stock/bond picking is nice, investors say no thanks when the whole basket of
stocks/bonds was rising. It is reasonable to say that ETF will cool down
because the market will eventually underperform active management, especially
when global QE stops.
However, I worry this won’t be the case. Overtime, it may be
become a habit that is hard to kick. After Japan suffered its bubble burst,
cheap 100 yen stores selling daily items sprung up and became part of life. 30
years later, it does not matter whether one is rich or poor, they all go to the
cheap 100 yen stores because it is a part of life. It also may be a genuine low
cost disruption that is here to stay. Regardless of whether it is piggy backing
on QE or not, ETF is a true innovation in terms of its efficiency and cost.
Similarly, fast fashion, ecommerce, ride sharing, and streaming have toppled
their incumbents in recent years and have not looked back. Lastly, the case for
ETF may be tied up in the same mystery of low inflation. In this low growth and
low return era, it is reasonable for investors to want to minimize their
management fees because they lack confidence.
*ETFs may also blow up and start a financial crisis due to
its now wacky construction, liquidity concerns, and bubble characteristics.
However, this discussion deserves a blog post of its own.
As of now, it is hard to say conclusively whether this is a
big fad or a big seismic shift, but either way it is impacting the financial
industry ecosystem. Due to the accessibility and popularity of ETFs through
robo advisors, financial advisors who make commission from helping investors
are hurting investors opt to “Do It Themselves.” Trickling down to the next
level, since people are buying ETFs instead of mutual funds, money managers who
charge a fee off their assets under management are pressured. Further down the
chain, investment banks who relied on money managers’ trading business are also
hurting. There is a chance that a counterbalance will set in since the ecosystem
change will impact the market in the long run, whether in its liquidity, asset
allocation, or productivity. However, until then, the pie for financial
analysts has shrunk and is shrinking.
Additional forces that threaten to reduce the size of the
pie are regulations. A European regulation called Midfid II will dictate how
money managers pay for research and it will lead to job losses. Before Midfid
II, money managers paid for research through soft dollar, which means they paid
for research through their trading commission they pay to the bank. Banks agreed
to it because at the very least, research was another service differentiator
that helped them stand out amongst the competition. Given the debates around
the usefulness of investment bank research and the squeezed margins for money
managers, many research firms will be caught swimming naked. Eventually, the
bottom performing research will get cut. Another US based regulation called
Fiduciary Duty Act, which aims to improve transparency and accountability, will
force financial professionals act in the best interest of their clients. One
direct effect is that financial professionals will now opt for the cheapest and
most convenient options because they want to stay out of trouble. Since ETFs
are cheap and popular, they will direct clients to ETFs because they don’t want
to have to explain themselves.
The passive management and current regulatory trend may be
the perfect storm for industry professionals. The laid off investment bank
research analysts will rush to get jobs at money managers, but money managers
are constrained. Not only is their revenue shrinking due to challenges from
ETF, but also their expenditure is growing because are forced to pay for research.
This means that a crowd of people will rush to squeeze into an already crowded
and possibly shrinking room.
As I said before, it is unclear what my financial analysis skillset
will get me in the future. If ETF is here to stay in the long run, then a
financial analyst may become no different than the horse breeder in early 20th
century. Both professionals have nice skills and both were valuable when horse
carriages and active management mutual funds ruled the world. However, if ETFs
becomes what car is to horse carriages, then financial analysts may suffer the
same fate. They either have to become the best analysts in the world and work
for Warren Buffet, similar to the horse breeders who work for the few domestic
and race horse owners, or they have to re-train and find a new job. They either
have to find something translatable or go into the automobile or new finance industry.
I maintain that either ETFs cools down or I am dead. Just
kidding, I won’t be dead. I will just have to think hard about where else I can
apply my skills or re-train for a new craft. I will not be the first to
experience this type of industry shifts, nor will I be the last.
*I will follow up with my own rebuttal piece about why I may
also be wrong and why the sky is not falling down.
