Just as banks have been so slow to innovate in the remittance and personal lending markets leaving room for digital startups to disrupt - Transferwise and Square in the remittance market and Venmo and Monzo in personal banking; retirement fund providers will have to move fast to capture the attention and money of the millennial generation from unicorns like Circle Invest and Square which are offering a new style of quasi-active money management.
“The future of the financial services industry is increasingly weightless, requiring few physical assets to establish or maintain a presence. That makes the industry especially vulnerable to disruption by digital competitors” - Pete Redshaw, Gartner VP
This new style of investing is the premise of cryptocurrency is to give people more control of their finances (‘be your own bank’) and be more active in its management, not hand it over every month to a third-party to invest every month. This passive approach has worked for almost 20 years but it has created its own risks: an asset management industry which has grown to a size of systemic importance reliant on a single overexposed and overleveraged long position in the stock market.
Like the banks, the fund industry is in for big change with the next generation of customer as they become accustomed to the financial freedom of moving money instantly and for free between different currencies, stablecoins and asset-backed tokens in a crypto wallet which obviates much of the service asset managers provide.
Crypto innovation to pioneer an active form of money management
Already there are crypto-saving platforms which provide a 401k-style dollar-cost averaging investment into the major cryptocurrencies.
Vimba is a non-custodial fiat-crypto onramp which automates buying in weekly, fortnightly or monthly installments and delivers it to users’ wallets in a quasi-active style of investing. The ‘active’ part a user plays is in choosing whether the currency stays on a hot wallet to use in exchange for other currencies or whether it is exported to a cold wallet for safe storage.
Circle, the first crypto unicorn, also provides a similar service through its Circle Invest platform where users can set up recurring payments. These innovative platforms sit in an area between fund provider and an exchange, using blockchain infrastructure (and OTC trading) to bring fees to a fraction of even the most low-cost ETFs. Although the market is still at a nascent stage the UI/UX on these platforms are arguably easier and faster than the labyrinth of funds and derivative products on incumbent fund websites.
Combined with the customization that digital banks provide customers with data on spending and budgeting, the ability to sync portfolio tools with crypto wallets and services such as Vimba and Circle via API will give a generation skeptical of traditional banks the ability to manage their own finances.
Too big to fail: The $22 trillion passive strategy
While there will always be a market for the fully passive investing style that has flourished since the invention of exchange-traded products, this overcrowded strategy could lose its popularity if it unravels as a systemic threat in the same way that collateralized debt obligations (CDOs) did in the 2007/8 global financial crisis.
The eight largest asset management shops in the US have amassed $22t in assets under management, up from $8t in 2006, according to research by asset manager Fasanara Capital. This can be partly attributed to the positive feedback loop of rising asset prices led by trend-following funds and managers, resulting in a highly correlated and concentrated level of risk in global stock markets and particularly in the asset management industry.
In 2014, the Financial Stability Board (FSB), the international body which monitors the global financial system, recommended that fund and asset managers be designated as “global systemically important financial institutions” due to the size of the sector. Such a categorization would have involved more regulatory oversight but after strong lobbying by the industry the designation was not applied.
The FSB also warned of a “liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units” - essentially ETFs have created an illusion of liquidity for assets as the number of funds has far outgrown the number of stocks underlying them and the ability to sell (or redeem) them during a mass sell off. For illustration of the imbalance, by the end of 2015, there were 9,500 mutual funds and 1,600 ETFs publicly available — but only 3,700 stocks available on exchanges in the US.
The fund industry: A passive-aggressive systemic threat
Around 90% of equity money flows today are passive (ETFs, passive index funds, risk parity funds) or quasi-passive (trend-following algos, momentum strategies, factor investing, machine learning); and 90% of strategies are trend or volatility-linked. This long stocks and short-volatility trade can be described as a giant $22t one-sided position.
There have already been warning signs about how quickly and sharply a reversal could happen when such an overcrowded passive trading strategy reaches a tipping point.
It happened most recently in the short S&P futures volatility trade (VIX index), the obverse trade to long stocks, which for two years was the fashionable trade from quantitative algorithmic traders to discretionary traders through short VIX ETNs (exchange traded notes).
In one sudden move in January last year the VIX shot up 3x, which was apparently ‘unforeseen’ and the risk of which was underestimated by many in the market.
In January 2018 a sudden spike in the VIX wiped out billions of dollars of short positions and even collapsed a VIX ETF. The virality of the short volatility trade has artificially suppressed implied volatility for years to around 10 and the risk of the VIX suddenly mean-reverting to its long-run average of ~18 was hugely underpriced and underappreciated.
Morgan Stanley had warned of the possibility of a blow-up in VIX-related short positions before the event, calculating the “the sensitivity to each percentage point change in vol, for the total universe of VIX related ETFs adjusted by their short interest. This vega stands at historical high levels currently."
And that is what transpired: when the VIX spiked the record-high volume of VIX-related shorts that had to cover went unmatched, resulting in a feedback loop where the higher VIX spiked, the more shorts had to cover.
What was just as remarkable is that as the VIX spiked 3x in one move, the S&P appeared unperturbed, dropping just over 1% from levels near all time highs, as if nobody even bothered to actually sell the underlying securities that set volatility.
This gives the appearance of a market in which the only securities traded are derivatives, with little regard for the actual stocks, which is the concern Fasanara Capital and others have expressed at the ETF trade - overleveraged and passively long the stock market.
How low volatility belies risk: Crypto less risky than stocks?
The perceived risk in bitcoin and crypto assets is always attributed to their high volatility and in the mainstream narrative the all-time low volatility of stocks is cited as a point in their favor. This can be partly explained by the finance world basing risk on retrospective VAR (Value at Risk) metrics, which equates high volatility with high risk.
However, it may transpire the opposite is true. Hyman Minsky, a macroeconomist who dedicated his research to financial crises, summated in his Financial Instability Hypothesis that “stability can be destabilizing” - economic agents observing a low risk are induced to increase risk taking, which in turn may lead to a financial crisis.
The volatility of 180-day returns of bitcoin (red) against the S&P 500 shows volatility in the crypto asset is around 10x that of the broader stock market. Chart: Coin Metrics
Similarly, in a recent study on Volatility and Financial Crises, Jon Danielsson of the London School of Economics reaffirmed Minsky’s “stability is destabilizing” theory: finding that long periods of low volatility having a strong predictive power over the incidence of a banking crisis, owing to excess lending and excess leverage. Most relevant to crypto, however, he observed that high volatility has little predictive power of a crisis.
The channel of falling monthly S&P volatility in the VIX index making lower lows and lower highs since the bull market started in 2010.
The Danielsson et al study found that the impact of low volatility reversal on the economy is highest if the economy stays in a low vol environment for five years; every 1% decrease below its trend translates to a 1.01% increase in the probability of a crisis. Today sitting around 14, the VIX has remained below its long-term average of 18.4 since 2012.
As we have previously covered, volatility has been artificially suppressed in the stock market which implies that market players have taken on far more more risk than they realize. Are we likewise seeing a false red flag for cryptocurrencies?
Fidelity Digital Assets the first-mover of incumbents
Fidelity, the largest pension fund provider in the US, is the first-mover in traditional fund space to embrace the digital asset class. Since 2014 it has researched blockchain and even mined bitcoin to explore the technology and it is soon launching an institutional-grade trading and custodial service, Fidelity Digital Asset Services, positioning itself to embrace blockchain for its services and as an investment class.
Helped by an historically large and avid generation of investors since the 1980s, the fund management industry has grown to a size of systemic importance: Blackrock, Vanguard, State Street and Fidelity between them have over $15t of assets under management, driven by passive investment funds like ETFs.
The chart above shows the largest demographic of workers reaching retirement age in US history is already underway.
Vanguard, while endorsing blockchain technology, has been dismissive of bitcoin and investing in cryptocurrencies as an asset. Its head economist Joe Davis has written that “the investment case for cryptocurrencies is weak”, and there’s “a decent probability that its [bitcoin’s] price goes to zero.”
In contrast to Fidelity’s chief executive Abigail Johnson who is famously in favour of making “digitally-native assets more accessible to investors”, Vanguard CEO Tim Buckley on record saying “you will never see a fund from Vanguard on bitcoin.”
Fidelity is also collecting crypto asset data - recently investing in market research firm CoinMetrics. Whether the Vanguard executives consider the asset class worthy of investment or not they will soon be pushed to offer crypto assets (or products thereof) to millennial customers to keep apace of rivals.
Despite the perceived risk and volatility in the crypto markets, conservative vehicles such as Yale University’s endowment fund and pension funds are moving into the space. Hedge fund manager Morgan Creek recently announced it received investments from two US pension funds into its digital asset venture capital fund.
Cambridge Associates, a consultant for pensions and endowments also recommended to clients: "Despite the challenges, we believe that it is worthwhile for investors to begin exploring this area today with an eye toward the long term".
What if fund managers are forced to buy the dips in crypto?
The asset management industry has benefited hugely from history’s biggest and wealthiest generation of investors, the baby boomers, by default of employer-defined pension plans. However, the incoming generation of customers aren’t guaranteed that employee privilege and so the fund industry can't focus as heavily on this one strategy as it has done.
Since the early 1980s the trajectory of the S&P 500 has seen an historically abnormal rate of growth as the baby boomers have bought every dip in the stock market since the 1980s.
The exponential bull trend in the SPX has been extenuated by the “buy the dip” strategy that retirement funds have adopted: rescuing the stock market from downturns in 1987, 2000 and 2007.
However, with the confluence of all the factors mentioned above, it looks increasingly as though the 30-year trend has been exhausted for the next generation of investors. The Federal Reserve of St Louis, described the 9-year stock market bull run “as a missed opportunity” for millennials as 60% of millennials lack stock market exposure and almost two-thirds of millennials in the US have next to nothing saved for retirement.
If 10% of the somewhere around 65 million millennials in the US, those Fidelity defines as between 21 and 37 years of age, invested 10% of their average income of $59,000 into crypto assets every year it would bring $38.3 billion into the market, or roughly a quarter of the current market capitalization.
While crypto pension options are currently limited to some niche Bitcoin IRA custodian services for wealthier individuals we will soon see the potential of all the components of the crypto ecosystem connecting together through APIs and blockchain wallets to provide a hybrid model of active money management that people can monitor in real-time, trade and use day-to-day. While we have focused here solely on the US retirement industry, the same themes are playing out in Europe as well. Tipping points in markets are never accurately known and can turn a snowflake into an avalanche in a moment. Wherever it comes from - trade war, geopolitical tension, quantitative tightening - if the long stock market trade plays out in the way the short VIX did we will see the end to passive investing as we know it.