Diversification's Role Under President Trump
Despite the quick sell-off and rebound in U.S. markets following Donald Trump's victory in his bid for President, industry trends like the move towards cost-reducing products can be expected to persist, according to an industry executive.
Maxwell Gold, the director of investment strategy at ETF Securities, says with the uncertainty surrounding President-elect Trump's regulatory policies in the year ahead, the ongoing trend to passive or smart beta products will continue.
"Even with the changes from the [Labor Department] and potential amendments with the new administration, I think this overall structural shift is going to persist," Gold says. "I can see ETFs as the vehicle of choice going into the medium-to-long term."
He added that there will continue to be an emphasis on diversification.
"I would expect continued development and innovation in the similar trends that we've seen in unique factor exposures and thematic investing, as well as accessing newer asset classes, particularly in ETF wrappers," he said.
Gold spoke with Money Management Executive last week. This is an edited version of the conversation.
How are you feeling about the future regulatory environment under President-elect Trump?
There's a lot of focus with the recent surprising results of the U.S. Presidential election. There have been a lot of questions and uncertainty. And that's the word of the day; not just from a policy perspective but also from a geopolitical and market perspective.
The immediate reaction was a gut reaction sell-off and then subsequent rebound of equities. We have seen a bit of a selloff in the commodities space, in particular precious metals. From a global perspective; the market environment that we've been dealing with before the election — and now after — hasn't changed.
Interest rate policies have been at record lows since the financial crisis, and the Federal Reserve is only now considering a tightening cycle beginning in December. When you take into account inflation that is really a key driver of markets and precious metals. We think that will resume going forward.
The key risk factor to pay attention to in 2017 is inflation. We see inflationary pressures continuing. The policies that have emerged from the new administration are inherently inflationary. Focus on the labor market and increasing jobs will also have inflationary impact to wages as we are already in a tight labor market. If we begin to see that tightening further, that should have inflationary pressures and impacts to the overall economy.
When you put that into perspective, the low negative or very low positive interest rate environment, not just here in the U.S. but globally, is really the challenge from a macroeconomic perspective. We have been in this tepid growth cycle following the financial crisis of 2008. Since then, policy makers, both monetarily and fiscally, having them scratching their heads and saying, "how do we help spur growth globally?"
What do you foresee as the impact of sustained pullback from equity markets?
It opens up continued concerns from investors, particularly those invested in cross asset classes where equities are expensive - they have been expensive and they continue to become more expensive.
Earnings are not spectacular. We just came out of an earnings recession just this quarter, but overall earnings over the past seven or eight years have been driven by cost reduction and not so much top line revenue or sales growth.
On the flip side, fixed income continues to remain and interest rates continue to be compressed from two factors. One is the accommodative monetary policies of low interest rates and increased central bank balance sheets. The other is increased injections of liquidity. By really risk averse investor populations, where investors demographics show they're gearing up for retirement, they're shifting their allocations to more conservative portfolios.
That drives the demand for yield and this hunt for interest yielding securities, primarily in the fixed income space. That has been a crisis in compressed yields.
This creates an environment of [there is no alternative], and this environment is most likely going to persist for 2017 as we've seen it play out in 2016. That's why we've seen such a run up beyond traditional asset classes; such as equities and fixed income, emerging markets, debts, commodities, precious metals and alternatives. I think this will persist.
Regardless of the new policies of the incoming administration, this is global macro-economic environment that we're living in, and these factors are not easy to reverse. This creates a challenging investment landscape whereby investors have to be tactically more opportunistic, think outside the box beyond traditional asset classes. That's why we're still constructive within the space we cover in commodities and precocious metals.
How will product development change under the incoming Trump administration?
We've seen a huge shift from active to passive investment strategies, and that's been partly in response to underperformance and high cost of active strategies as well as the interest of broad-based exposures and diversification. ETFs offer a great way to do that relative to other fund vehicles like mutual funds.
We have seen that shift continue where outflows of active strategies into more passive or smart beta or thematic investing through ETFs, and even in the alternatives space. We have seen large attention to investing through alternatives strategies such as commodities and precious metals. I don't see that trend reversing quickly. Once you go into an environment where you can achieve investment exposures and investment strategies on a cheaper basis, it's harder to make the argument and say, "We are achieving our exposures how we see fit as investors. Why would we actively pay for performance that may not be worth the expense?"
There are some active strategies that may be worth the higher expense ratio. The trend we've been seeing at the institutional level is that cost isn't much of a focus because these investors are investing over very long periods of time; such as endowments, foundations, pension funds and defined contribution funds. The environment is becoming an even more commoditized investment landscape and price compression is going to continue.
It is going to be very challenging for fund providers and investors to say they'll go back to a regime where they're paying much higher expenses for similar exposures and achieve cheaper options through ETFs, in a more transparent perspective. Once you've gone through that point, you have passed the rubicon where it's a tough switch to go back to the status quo that we've seen, say 10 years ago when they brought up the option of ETFs.
Even with the changes from the DoL and potential amendments with the new administration, I think this overall structural shift is going to persist. A lot of providers that were even primarily in the mutual fund space see the benefit of expanding into ETFs, so I can see ETFs as the vehicle of choice going into the medium-to-long term.
Bloomberg reports that low-volatility ETFs have amassed billions of dollars as scared investors fled higher-yielding investments after the election. Do you see this continuing?
In this market environment, the scarcest commodity is actually diversification. I think that's why we've seen a lot of interest in new products emerge that are now focused on different factors; betas, strategies and focusing on the role of diversification. I do expect that environment to persist, particularly with the fact that we've been experiencing continued uncertainty and volatility throughout 2016.
Overall I do expect policy — market and geopolitical uncertainty — to persist in 2017. That environment is most likely going to create a lot of volatility across asset classes. The issue here is that what we've seen emerge in certain trading days is actually traditional correlations amongst equities and treasuries, which typically have a negative correlation.
You are beginning to see that correlation deteriorate when we see these large swings in markets where negative or correlating assets are beginning to move in tandem under certain periods of direst, or large volume trading.
That's the case we've seen after every historical financial crisis, where following every large market event going back even 40 years, we do see a large selloff or most asset classes move in tandem, or correlated highly. Once the crisis emerges, we do see a reduction of intercorrelation amongst these asset classes, but we do see it persist at a higher elevated level before that crisis. Even the 2008 financial crisis was no exception.
This environment is really a challenging landscape for investors, which is why I think there is this new focus on creating products that are at the heart either providing new access to investment exposures or focused on creating diversification.
In particular with U.S. products we have backed ETFs, so we have seen large inflows here and expect to see them continuing in 2017 and 2018. That's because the investment environment that we're dealing with is very challenging to diversify your risk exposures.
In an environment where we do see persistent uncertainty surrounding longer growth and rising inflation, we expect to see this [there is no alternative] effect where you would have to think outside the box and beyond the traditional landscape of just stocks and bonds.
That's why we've seen a lot of interest from both sides for these ETFs that can help manage that volatility and risk and provide true diversification.
Is there a product that doesn't exist now that you think could capture some of this volatility that we're expecting going forward?
I would expect continued development and innovation in the similar trends that we've seen in unique factor exposures and thematic investing, as well as accessing newer asset classes, particularly in ETF wrappers.
I think there's a large amount of asset classes in the traditional alternative asset bucket, or the commodity bucket, that I think could potentially come to market that would increase efficient accessibility to these asset classes that investors currently don't have a great way to implement their views and in an environment.
While we do see further impetus for diversification for getting beyond just your traditional asset classes to try to manage a lower expected return, and higher expected volatility environment, I think looking beyond stocks and bonds in the alternative investment space is going result in a lot of innovation and development across those sub asset classes.