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Mutual fund conversions to ETFs set to gather momentum, experts say

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Moves by two US asset managers to convert some of their mutual funds into exchange traded funds could trigger a wave of copycat manoeuvres by rival houses, industry figures believe.

Texas-based Dimensional Fund Advisors said this week it intends to convert six of its mutual funds, with total assets of $20bn, into actively managed ETFs during 2021. It has also launched its first ever standalone ETFs, two of which listed last week.

DFA is following in the footsteps of Guinness Atkinson, a small Californian boutique, which hopes to convert two mutual funds with assets of $21m into ETFs by the end of the year in an industry first.

Few believe the two providers will be the last to transition towards the faster-growing fund structure.

“I think in hindsight we could very well look back at this moment and say this is a significant trend,” said Ben Johnson, director of global ETF research at Morningstar.

“I think we will see other asset managers taking notes, observing this closely and looking to re-platform current strategies, which they already have as a mutual fund, as an ETF.”

Sean Tuffy, head of market and regulatory intelligence at Citigroup Securities Services, said it was a “significant step in the evolution of the ETF industry”, and “an efficient way to launch a scale ETF business”.

Robert Tull, president of asset management-to-consultancy Procure Holdings and an ETF industry veteran, said he was “surprised” other houses had not already taken the step.

“It’s very unusual for people to do what DFA is doing, but I think it’s the right thing to do. I think more people could do it if they can show it works,” he said. “The ETF is giving the investor a better product for less money.”

Although the US mutual fund industry is still far larger than its ETF counterpart, with assets of $21.3tn at the end of 2019, versus $4.4tn for ETFs, according to the Investment Company Institute, investors are increasingly voting with their wallets in favour of the latter.

Just 32 per cent of US mutual fund complexes saw net inflows of fresh money last year, according to the ICI. This figure has sat below the 50 per cent break-even mark every year since 2014.

In contrast, 74 per cent of ETF sponsors saw positive share issuance last year, a continuation of the rapid growth witnessed for the past decade as assets have quadrupled.

Column chart of Percentage of fund complexes showing Positive net cash flow to mutual funds and positive net share issuance of ETFs

US mutual funds are being hurt by regulations that trigger a capital gains tax liability for all shareholders whenever the manager is forced to sell holdings in order to meet redemption requests. ETFs, by dint of their structure, are generally immune from such liabilities.

As investors increasingly switch to ETFs, which tend to be cheaper, an acceleration in redemptions can potentially trigger rising tax liabilities for those mutual fund investors that remain — assuming they are not investing via tax-exempt accounts. This is creating a damaging feedback loop.

Simultaneously, the advent of semi-transparent ETFs in the US, which do not need to reveal their portfolios on a daily basis, has made the format more attractive for active fund managers, rather than just passive ones.

Mr Johnson characterised DFA’s move as “a defensive play”, given that the six funds to be converted had $2.4bn pulled from them in the first 10 months of the year. He also said there was a preference for ETFs among DFA’s core clientele of registered investment advisers.

“These six funds have been plagued by outflows and there is a very little mutual fund managers can do to address the tax issues when there are outflows. They have to distribute taxable capital gains,” Mr Johnson said.

Gerard O’Reilly, co-chief executive and chief investment officer of DFA, said the six funds to be converted already had similar tax efficiency to ETF products, but that the move would “provide an additional tool to manage capital gains”.

He accepted that DFA had seen investor outflows, but said the timing was driven more by regulatory changes that have eased the way to launch active ETFs. DFA describes itself as a systematic active manager.

DFA is also cutting fees on the funds by an average of 27 per cent, a move it said was part of a multiyear process of lowering charges across the board. Mr Tull said that did not necessarily mean lower margins, as it might save on distribution and shareholder record-keeping costs.

Even if fund conversions did lower margins, though, he believed asset managers would increasingly have to bite the bullet, even if this meant losing assets from their remaining mutual funds.

“If you don’t control the process, someone else will. If you are worried about cannibalisation, you can eat your young or someone else will. It’s your choice. ETFs are bleeding assets out of the mutual fund industry,” Mr Tull said.

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Moreover, converting an existing mutual fund into an ETF rather than simply launching a sister vehicle has the advantage of maintaining a track record and immediately having the scale needed to attract large investors.

DFA will become the 12th largest ETF manager in the US, ahead of Goldman Sachs, Fidelity and DWS, according to data from TrackInsight.

Given that the discrepancy in tax treatment is a purely US issue, Mr Johnson did not believe that fund conversion was “going to catch on anywhere outside US borders”.

However Mr Tuffy disagreed, arguing that the growing popularity of ETFs was a broader phenomenon.

“Once a few managers have successfully undergone the process, I think it’s something European fund managers will consider,” he said. “European managers may try to replicate it.”



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European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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