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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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US stocks rise as investors weigh strong earnings against spread of Delta variant

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Equities updates

Stocks on Wall Street edged higher on Tuesday as strong company earnings and economic data offset worries about the spread of the Delta coronavirus variant and fears over another regulatory clampdown from Beijing.

The blue-chip S&P 500 was up 0.7 per cent by mid-afternoon in New York, its best performance in more than a week. The tech-focused Nasdaq Composite climbed 0.3 per cent.

Investor sentiment was lifted by June data for US factory orders, which typically feed into estimates of gross domestic product. New orders for goods rose 1.5 per cent on the month before, well above the consensus estimate of 1 per cent.

In Europe, another wave of strong earnings results helped propel the continent’s stocks to a fresh record. The region-wide Stoxx 600 index rose 0.2 per cent after Paris-based bank Société Générale and London-listed lender Standard Chartered reported profits that beat analysts’ expectations.

London’s energy-leaning FTSE 100 index rose 0.4 per cent, aided by oil major BP, which rallied after announcing a $1.4bn share buyback programme and an increase in its dividend.

Line chart of Stoxx Europe 600 index showing Strong earnings help propel European shares to record high

On both sides of the Atlantic, earnings have been strong. More than halfway through the US reporting season, 86 per cent of companies have topped expectations on profits, while in Europe 55 per cent have outperformed so far, according to data from FactSet and Morgan Stanley.

“The continued healthy earnings outlook is a key driver of our view that the equity bull market remains on solid footing,” analysts at UBS Wealth Management wrote in a note. Such a growth rate is, however, “flattered by depressed levels in the year-ago period,” they said. “But the results are still impressive compared with pre-pandemic earnings.”

Oil slipped in a choppy session as the global benchmark Brent crude fell 0.7 per cent to $72.37 a barrel on fears that the spread of the Delta variant could depress demand for fuel.

The seven-day rolling average for new coronavirus cases in the US, the world’s largest economy, have hit nearly 85,000 from about 13,000 a month ago, according to the Financial Times coronavirus tracker. Similar trends have taken hold in other countries as well as authorities race to vaccinate larger swaths of their populations.

A log-scale line chart of seven-day rolling average of newcases showing that US coronavirus case counts rise from just over 10,000 in mid-June to nearly 100,000 by early August

In Asia, investors were again focused on regulation after Chinese state media criticised the online video gaming industry, calling it “spiritual opium”. Shares in Tencent, the Chinese internet group, fell 6 per cent before announcing it would implement new restrictions for minors on its gaming platform. NetEase and XD, two rivals, dropped 7.8 per cent and 8.1 per cent, respectively.

The Hang Seng Tech index, which includes Tencent and its peers, dropped 1.5 per cent, lagging behind the wider Hong Kong bourse, which slipped 0.2 per cent. The CSI 300 index of large Shanghai- and Shenzhen-listed stocks was flat.

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Why it might be good for China if foreign investors are wary

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Chinese economy updates

The writer is a finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center for Global Policy

The chaos in Chinese stock markets last week was exacerbated by foreign investors selling Chinese shares, leaving Beijing’s regulators scrambling to regain their confidence while they tried to stabilise domestic markets. But if foreign funds become more cautious about investing in Chinese stocks, this may in fact be a good thing for China.

In the past two years, inflows into China have soared by more than $30bn a month. This is partly because of a $10bn-a-month increase in the country’s monthly trade surplus and a $20bn-a-month rise in financial inflows. The trend is expected to continue. Although Beijing has an excess of domestic savings, it has opened up its financial markets in recent years to unfettered foreign inflows. This is mainly to gain international prestige for those markets and to promote global use of the renminbi.

But there is a price for this prestige. As long as it refuses to reimpose capital controls — something that would undermine many years of gradual opening up — Beijing can only adjust to these inflows in three ways. Each brings its own cost that is magnified as foreign inflows increase.

One way is to allow rising foreign demand for the renminbi to push up its value. The problem, of course, is that this would undermine China’s export sector and would encourage further inflows, which would in turn push China’s huge trade surplus into deficit. If this happened, China would have to reduce the total amount of stuff it produces (and so reduce gross domestic product growth).

The second way is for China to intervene to stabilise the renminbi’s value. During the past four years China’s currency intervention has occurred not directly through the People’s Bank of China but indirectly through the state banks. They have accumulated more than $1tn of net foreign assets, mostly in the past two years.

Huge currency intervention, however, is incompatible with domestic monetary control because China must create the renminbi with which it purchases foreign currency. The consequence, as the PBoC has already warned several times this year, would be a too-rapid expansion of domestic credit and the worsening of domestic asset bubbles. 

Many readers will recognise that these are simply versions of the central bank trilemma: if China wants open capital markets, it must give up control either of the currency or of the domestic money supply. There is, however, a third way Beijing can react to these inflows, and that is by encouraging Chinese to invest more abroad, so that net inflows are reduced by higher outflows.

And this is exactly what the regulators have been trying to do. Since October of last year they have implemented a series of policies to encourage Chinese to invest more abroad, not just institutional investors and businesses but also households.

But even if these policies were successful (and so far they haven’t been), this would bring its own set of risks. In this case, foreign institutional investors bringing hot money into liquid Chinese securities are balanced by various Chinese entities investing abroad in a variety of assets for a range of purposes.

This would leave China with a classic developing-country problem: a mismatched international balance sheet. This raises the risk that foreign investors in China could suddenly exit at a time when Chinese investors are unwilling — or unable — to repatriate their foreign investments quickly enough. We’ve seen this many times before: a rickety financial system held together by the moral hazard of state support is forced to adjust to a surge in hot-money inflows, but cannot adjust quickly enough when these turn into outflows.

As long as Beijing wants to maintain open capital markets, it can only respond to inflows with some combination of the three: a disruptive appreciation in the currency, a too-rapid rise in domestic money and credit, or a risky international balance sheet. There are no other options.

That is why the current stock market turmoil may be a blessing in disguise. To the extent that it makes foreign investors more cautious about rushing into Chinese securities, it will reduce foreign hot-money inflows and so relieve pressure on the financial authorities to choose among these three bad options.

Until it substantially cleans up and transforms its financial system, in other words, China’s regulators should be more worried by too much foreign buying of its stocks and bonds than by too little.



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Square to acquire Afterpay for $29bn as ‘buy now, pay later’ booms

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Square Inc updates

Payments company Square has reached a deal to acquire Australian “buy now, pay later” provider Afterpay in a $29bn all-stock transaction that would be the largest takeover in Australian history.

Square, whose chief executive Jack Dorsey is also Twitter’s CEO, is offering Afterpay shareholders 0.375 shares of Square stock for every share they own — a 30 per cent premium based on the most recent closing prices for both companies.

Melbourne-based Afterpay allows retailers to offer customers the option of paying for products in four instalments without interest if the payments are made on time.

The deal’s size would exceed the record set by Unibail-Rodamco’s takeover of shopping centre group Westfield at an enterprise value of $24.7bn in 2017.

The transaction, which was announced in a joint statement from the companies on Monday, is expected to be completed in the first quarter of 2022.

Afterpay said its 16m users regard the service as a more responsible way to borrow than using a credit card. Merchants pay Afterpay a fixed fee, plus a percentage of each order.

The deal underscored the huge appetite for buy now, pay later providers, which have boomed during the coronavirus pandemic.

“Square and Afterpay have a shared purpose,” said Dorsey. “We built our business to make the financial system more fair, accessible, and inclusive, and Afterpay has built a trusted brand aligned with those principles.”

Adoption of buy now, pay later services had tripled by early this year compared with pre-pandemic volumes, according to data from Adobe Analytics, and were particularly popular with younger consumers.

Rivalling Afterpay is Sweden’s Klarna, which doubled its valuation in three months to $45.6bn, after receiving investment from SoftBank’s Vision Fund 2 in June. PayPal offers its own service, Pay in 4, while it was reported last month that Apple was looking to partner with Goldman Sachs to offer buy now, pay later facilities to Apple Pay users.

Steven Ng, a portfolio manager at Afterpay investor Ophir Asset Management, said the deal validated the buy, now pay later business model and could be the catalyst for mergers activity in the sector. “Given the tie-up with Square, it could kick off a round of consolidation with other payment providers where buy now, pay later becomes another payment method offered to their customers,” he said.

Over the past two years Afterpay has expanded rapidly in the US and Europe, which now account for more than three-quarters of its 16.3m active customers and a third of merchants on its platform. Afterpay said its services are used by more than 100,000 merchants across the US, Australia, Canada and New Zealand as well as in the UK, France, Italy and Spain, where it is known as Clearpay.

Square intends to offer the facility to its merchants and users of its Cash App, a fast money transfer service popular with small businesses and a competitor to PayPal’s Venmo.

“It’s an expensive purchase, but the buy now, pay later market is growing very rapidly and it makes a lot of sense for Square to have a solid stake in it,” said retail analyst Neil Saunders.

“For some, especially younger generations, buy now, pay later is a favoured form of credit. Afterpay has already had some success with its US expansion, but Square will be able to accelerate that by integrating it into its platforms and payment infrastructure — that’s probably one of the justifications for the relatively toppy price tag of the deal.”

Square handled $42.8bn in payments in the second quarter, with Cash App transactions making up about 10 per cent, according to figures released on Sunday. The company posted a $204m profit on revenues of $4.7bn.

Once the acquisition is completed, Afterpay shareholders will own about 18.5 per cent of Square, the companies said. The deal has been approved by both companies’ boards of directors but will also need to be backed by Afterpay shareholders.

As part of the deal, Square will establish a secondary listing on the Australian Securities Exchange to provide Afterpay shareholders with an option to receive Square shares listed on the New York Stock Exchange or the ASX. Square may elect to pay 1 per cent of the purchase price in cash.

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