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There's a downside to passive ETF investing – The Globe and Mail

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Passive investing strategies are becoming a victim of their own success. In the process, they are shaking the foundations on which they were built, distorting markets and introducing unintended risks.

The risks are acute: markets are now comprised of the highest proportion of passively-managed assets than ever before and, in periods of high market volatility, the distortive effects are more pronounced.

Low-cost market tracking, diversification and reduced volatility are key pillars of passive strategies that underlie index and exchange-traded-fund (ETF) investing.

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Yet the explosive growth in passive investing has begun to undermine the very characteristics which are perceived to be their most important advantages vs. active investment management.

Passive funds are no longer market bystanders, but important influencers that transact daily in ever-growing amounts.

Index funds and ETF’s are governed by simple rules: when the funds attract inflows from investors, they buy the underlying securities in the particular index or group; when they experience outflows, they sell them.

These funds hold virtually no cash, exercise no discretion nor perform any fundamental analysis. They are, in and of themselves, devoid of any sensitivity to the valuation or fundamentals of markets and the securities that underlie them.

For passive strategies to deliver their purported benefits, they are implicitly reliant on active market participants to perform two critical functions.

One is to act as an adjudicator of valuation through their collective decision-making as reflected by share prices. In essence, the Efficient Market Hypothesis is at the core of all passive strategies.

The second is to provide the liquidity necessary to enable the passive funds to buy or sell the underlying securities as dictated by their inflows and outflows.

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For example, Microsoft is estimated to be a component in a staggering 145 ETFs. If fund inflows require that passive funds buy MSFT shares, active managers are an important source of the supply necessary to meet that demand. But assuming the current price of Microsoft already reflects the aggregate wisdom of all market participants, this new demand will drive its price and valuation unjustifiably higher.

While seemingly innocuous, the reverse situation also occurs. If active managers’ purchasing power cannot offset the supply from passive fund outflows, stocks will continue to fall, often with devastating effects.

As passive funds become the dominant investment vehicles in the markets they crowd out actively managed funds and distort the value of the markets they are designed to track. The larger ETFs grow as a percentage of the overall market, the greater this distortion.

The growth in passive funds has another consequence – increased correlation. Stocks that underlie passive investments are bought and sold in a basket; they become welded together. This alone undermines the diversification benefits of ETF investing.

Additionally, as certain stocks become ever-larger components of various indices and ETFs (the FAMGA stocks for example), individual security concentration reduces diversification even further.

Higher correlation results in higher volatility, affecting market performance. Reacting more than ever to passive fund flows, markets tend to overshoot on both the upside and downside. The liquidity that would typically be provided by active managers, especially as valuations trend towards extremes, is overwhelmed by the passive flows.

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The cumulative distortive effects on markets is particularly evident in severe drawdowns like the one we recently experienced. Passive funds facing outflows are forced to indiscriminately sell the underlying components of the index fund or ETF, irrespective of industry sector or fundamentals.

Active management may again have its day, albeit in a new and improved iteration.

Passive strategies are reliant on active participants to function as intended and, in times of increased uncertainty, investors may find it worthwhile to entrust their assets to those who perform real fundamental analysis.

To quote John Bogle, the father of passive investing and founder of Vanguard, “If everybody indexed, the only word you could use is chaos, catastrophe…The markets would fail.”

Jeff White is found and CEO of Hinge Markets Inc., a capital markets advisory firm

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Weekly investment update – 3 June 2020 – Investors' Corner BNP Paribas

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growth in mortality rates, however, has fallen by nearly half from the March-April peaks, reflecting the shift in the focus of the pandemic towards emerging markets. Here, mortality rates have been consistently lower than in developed markets. Meanwhile, curves continue to flatten in the US and in particular in major European economies. Globally, deaths topped 382 000, as of 3 June.

Easing spreads across Europe

All major European countries have now eased the restrictions put in place to slow the spread of COVID-19, the Oxford Stringency index shows. Some countries are easing faster than others. Italy, in particular, stands out. Where the restrictions were once seen as the toughest in Europe, Italy now ranks as the laxest, with Spain now assessed to have the toughest regime.

Latin America remains the current pandemic hotspot: four out of the 10 countries reporting the highest number of new infections in recent days are from the region: Brazil, Peru, Chile and Mexico.  

Brazil is now second only to the US in terms of confirmed cases and is fourth in fatalities after the US, UK and Italy. Brazil’s mortality curve remains worrying, and since there is no national lockdown, it is hard to tell when the peak will be reached.

No plain sailing after lockdown

Meanwhile, events in South Korea remind us that managing the virus outside of lockdown is not straightforward even for the best-in-class regime. South Korea reintroduced quarantine measures for the next two weeks due to the recent uptick in cases: parks, museums and art galleries were temporarily closed and school quarantine and distancing rules in Seoul were tightened.

On Thursday, 79 new cases had emerged, the highest since early April. Most of them were attributed to a single distribution centre for an online retailer. The new cluster led provincial governments in the region to postpone plans to reopen schools for kindergarteners and primary schoolers on Wednesday, although most of the country’s schools have reopened as planned.

Economic policy

The main news in recent days has been the announcement by the European Commission of the details of the long-term budget, the Multiannual Financial Framework (MFF), and its response to the current crisis, Next Generation EU. 

Markets had focused on the latter. The Commission proposes a EUR 500 billion package of grants and EUR 250 billion in loans to be financed by debt issued in the capital markets. This is backed by the headroom in the EU budget between actual spending and the theoretical limit on the funds that the EU can claim from the member states.

Next Generation EU sets out an important principle: establishing a genuine fiscal capacity at the centre of Europe, which can be deployed to support demand in member, states that are hit by large shocks.

However, the details of the package are yet to be agreed by all member states. It seems likely that the generosity of the scheme may be diluted in the search for a compromise. The scale of the net transfers may be reduced. The conditionality attached to funds that already exists may be strengthened. The split between grants and loans may be recalibrated.

Political news

There have been two significant developments:

  • The fallout from the decision by the Chinese authorities to introduce national security legislation in Hong Kong’s Basic Law. This has added to tensions in Sino-US relations over and above the blame game over the virus and an uneasy truce in the trade/tech war. There is a real risk of an escalation with obvious market consequences: China’s Foreign Ministry has warned, “Any words or actions by the US that harm China’s interests will meet with China’s firm counterattack.”
  • In the US, George Floyd’s death has led to widespread public protest and instances of violence that prompted the authorities to impose curfews in cities and deploy the National Guard in multiple states. As yet, it is unclear whether this latest tragedy will trigger a moment of national reflection on the question of racial injustice and ultimately positive change, and whether more immediately it affects the presidential election.

Market Outlook

  • In an encouraging sign, US continuing claims for unemployment benefits have dropped for the first time since February. This points to the first green shoots in the labour market as quarantine restrictions are lifted. Any recovery hinges on improving employment for the bounce-back to be sustainable over the medium term. It is also crucial to keep social tensions to a minimum.
  • We believe the economic environment remains weak and that the recovery will take longer than expected. This assessment is echoed by the ECB. Most developed economies will not have returned to the 2019 levels of activity by the end of 2021. In Europe, a greater dispersion in growth among countries has increased divergence. This is a key reason to have a unified fiscal approach, as per the latest European Commission proposal (see above).
  • We expect further stimulus and central bank support given this weak outlook. On 4 June, the ECB is expected to announce a EUR 500 billion increase of its PEPP programme. It comes on top of the EUR 750 billion package proposed by the Commission. Extra packages by Japan, China and Germany all aim at securing a recovery and stabilising badly hit small and medium-sized firms.
  • Government and central bank support is expected to ease financial conditions, especially in Europe where they have remained restrictive, and could lower the risk premium of eurozone assets and support the euro.
  • The current backdrop supports risky asset valuations, even as the real economy struggles. The outlook for the US dollar is less solid: carry and growth advantages over the rest of the world have dissipated and political risk, once a US dollar supportive factor, has become a headwind.
  • Investment-grade (IG) corporates have been tapping the market at a record pace and rotating away from funding via commercial paper (CP). This is further easing the stress on USD liquidity and demand for the US currency. Moreover, it creates a stronger liquidity backdrop for higher-rated corporates. That said, we see continued stress for the weaker companies and sectors most affected by the virus outbreak, creating greater dispersion in credit and equity markets.
  • A slow weakening of the USD could enhance emerging market (EM) carry trades. Prospects look better for the less volatile Asian currencies over the more market-sensitive currencies as many of these countries have now become the new epicentres of the COVID-19 crisis (see above).

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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Ontario investing $150 million to improve broadband, cell service for rural communities. | News – Daily Hive

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Ontario has announced it is investing $150 million in “reliable broadband and cellular service.”

According to the province, this funding will help create even more economic and educational opportunities in rural, remote, and underserved areas of the province.

“As we carefully restart the economic engine of Canada, every region and every community will play a role in bringing jobs and prosperity back to our province,” said Premier Doug Ford.

“By investing in reliable broadband and cellular service, we are helping to create greater opportunity for our families, farmers, and small business owners in rural and remote areas of this great province.”

The new Improving Connectivity in Ontario, or ICON, program, when leveraged, has the potential to result in an investment of up to $500 million in total partner funding to improve connectivity in underserved and unserved areas, according to the province.

“By doing their part and staying home to help stop the spread of COVID-19, the people of Ontario have demonstrated the need to be connected to learn, work, and run their businesses,” said Infrastructure Minister Laurie Scott. “It appears that functioning remotely will continue to be a regular way of life for many in this new environment, and fast reliable Internet will be critical. The ICON program is an important step towards bridging the digital divide in Ontario.”

The province said as many as 12% of households in Ontario are underserved or unserved, mostly in rural, remote or Northern areas.

And with Ontario’s education now online, it is an important component of the province’s plan.

The provincial government recently called on the federal government to take immediate action to improve Internet connectivity for Ontario students.

“Access to high-speed Internet is foundational to our young people’s success in learning, working, and innovating, today and into the future,” said Minister Stephen Lecce.

“Our government is taking action by connecting all schools to broadband, starting with high schools this September 2020 and elementary schools by September 2021. It is also why we are calling on the federal government to step up their investment to connect the next generation of thinkers and workers to the modern and digital economy.”

  • See also: 

On Tuesday, Ontario extended the province’s state of emergency for another 28 days, until June 30.

Ford said that this doesn’t mean the reopening of the economy is on hold, and that the province will continue to look into a regional approach.

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Jeff Bezos' investment into Beacon is 'personal' and not tied to Amazon, UK firm's CEO says – CNBC

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Jeff Bezos’ investment in digital freight forwarding and supply chain finance firm Beacon is a personal one, the U.K. start-up’s CEO told CNBC Wednesday after the closing of its $15 million Series A funding round. 

“I should be really clear that this investment is from Mr. Bezos directly. It’s a personal investment, not one made by Amazon. Amazon is aware and had to approve of it, but there is no commercial relationship and this has no direct tie with Amazon itself and it’s important to make that distinction,” Beacon CEO Fraser Robinson said. 

The backing from Amazon CEO Bezos, who has invested in numerous start-ups, is set to be a major boost for the company in its stated mission to be a global leader in logistics and trade finance. Its investors also include former Google Chairman Eric Schmidt and Uber founders Travis Kalanick and Garrett Camp. Its current executives were previously in senior roles at Uber and Amazon.

Beacon, based in London and founded in 2018, wants to disrupt the global shipping industry by using A.I. to find the cheapest shipping routes while offering customers supply chain financing to help cashflow. 

The freight forwarding industry, or how goods move from the manufacturer to market, is worth $1 trillion. Robinson sees Beacon’s role as meeting the need for the industry to become more digitized. 

“We were surprised by how analogue the existing logistics industry is,” he said. “By automating and streaming and creating huge efficiencies within our own operating platform, that means we can provide a vastly superior service to our customers — with automated updates, superior route optimization, and the working capital to fulfil what we see as one of the greatest problems created by logistics, which is cashflow.”

Asked about the potential for established shipping giants like DHL and Maersk to use the same technology and sharpen the competition, Robinson said he expects the industry to digitize itself.

“It’s a trend that is already happening and has been going on for a couple years,” he said, but noted that “it’s much more difficult than people realize for large companies to retrofit technology and make themselves more efficient overnight. Typically they’re either buying technology or buying businesses to help them get there.” 

“By starting with a technology focus first and foremost and being data centric, I think you have a better shot at a more holistic solution that’s more scalable and more effective,” Robinson said.

He also sees Uber Freight, Uber’s trucking arm for the shipping industry, as potentially a useful complement to Beacon’s wider business, rather than competition. That’s because the trucking operation is just one piece of the longer and more complex process of getting goods across land, sea and air to their final destinations. Uber last year announced it would invest $200 million and hire thousands of engineers to boost its freight platform. 

“The truckload piece, the Uber Freight piece, is a component of what we do, and they can and will be a great partner for us as part of the solution we provide, but it’s fundamentally a very different business,” Robinson said.

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