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By comparing two low-volatility offerings in the US, it’s easy to see why ETFs continue to gain at the expense of other funds.

I’m referring to Invesco Powershares’ S&P 500 Low Volatility ETF (NYSE Arca: SPLV) which, as we wrote about yesterday, has attracted over US$1 billion in assets since its launch in May last year, and Janus Intech’s actively managed low volatility strategy.

Invesco Powershares is the fourth-largest US manager of exchange-traded funds. Janus doesn’t yet offer ETFs (though it did apply last year to the US regulator to launch some actively managed ones).

Invesco Powershares saw US$4.4 billion of ETF inflows last year, well short of the US$36 billion, US$29 billion and US$17 billion recorded, respectively, by Vanguard, BlackRock and SSgA, the US market’s biggest three ETF firms. But Powershares’ inflows were still respectable and totalled over 10 percent of the firm’s previous year-end assets. SPLV was a particularly successful launch and made up around a quarter of the new money arriving.

Janus's asset management business, meanwhile, suffered net redemptions in all four quarters of 2011.

There are two simple reasons why ETFs continue to gain market share from traditional funds: they are cheaper and more flexible.

Janus’s Intech subsidiary, which specialises in quantitative equity portfolios, charges 0.35 percent to manage a separate managed account following a low-volatility approach. Separate accounts command the lowest (wholesale) rates available in fund management and Janus sets a minimum portfolio size of US$50 million. Although it doesn’t offer a pooled fund version of its low volatility strategy, for its other mutual funds, which have a minimum investment amount of US$1 million, Janus typically adds another 20 basis points to the separate account rate.

Invesco Powershares, meanwhile, charges only 0.25 percent for its ETF. You can buy a single ETF share for US$26, making the fund accessible for everyone (I’m ignoring the brokerage commissions and bid-offer spread you face when dealing in an ETF, but for an investment amount of a few thousand dollars in a relatively liquid fund these are minimal). By comparison with a traditional mutual fund or separate managed account, the ETF, let’s remember, also offers intraday tradeability, real-time performance benchmarking against its index and full transparency of its holdings.

The two funds’ management approaches are not identical: the S&P 500 low volatility index tracked by the Invesco Powershares ETF, SPLV, uses a simple ranking of one-year historical volatilities to select 100 shares from the broader S&P 500 stock index, giving those with the lowest recorded risk a higher weighting. Intech uses a more complicated, minimum variance algorithm to reduce volatility and stresses in its marketing literature that its estimates of stocks’ historical variability of return, and of their interconnectedness, are proprietary, and “can be quite different from peers’ portfolios, which use off-the-shelf risk models”.

You’re paying quite a bit extra, in other words, for a less transparent, tailor-made approach to minimising risk. With the cheaper, index-based strategy of the ETF, you know what you’re getting and you can see how it is put together.

Judging by the 2011 fund flow figures, the contest between ETF managers and their more expensive active counterparts is very uneven. Investors continue to vote with their feet, deciding that they are quite happy to go down the indexed route and leave behind the more expensive, proprietary and less flexible option.

Hedge fund managers basically offer a “heads I win, tails you lose” bet to their clients, something investors appear surprisingly happy to sign up to. The hedge fund industry’s assets surpassed pre-crisis levels last spring, according to State Street, although the average fund ended up losing 5 percent during 2011.

It’s presumptuous to question the sanity of investors controlling US$2 trillion. All the same, I’d be interested to hear their collective take on the astonishing figure reported by Jonathan Davis in the Financial Times earlier this week.

“Between 1998 and 2010,” says Davis, quoting from a new book by Simon Lack called The Hedge Fund Mirage, “even on favourable assumptions hedge fund managers earned an estimated US$379bn in fees, out of total investment gains (before fees) of US$449bn. In other words, they took 84 per cent of the investment profits their funds made, leaving just 16 per cent for the investors.”

Principal-agent problems (to use economists’ jargon for a biased coin toss) aren’t confined to hedge funds. Private equity fund managers enjoy a very similar fee structure, this time with tax breaks thrown in. In the banking sector, a taxpayer guarantee has underwritten the large cheques employees have been paying themselves at the expense of bank owners. Over the last decade, those bank shareholders have been led by the nose to the same slaughterhouse as the average hedge fund investor.

Share options, supposedly there to align the interests of managers and shareholders, can easily end up incentivising the pursuit of short-term share price gains at the expense of companies’ long-term health. In fact, conflicts of interest are embedded in all limited liability corporations. The high debt levels at banks, hedge funds and in private equity firms’ leveraged buyouts only serve to exacerbate the problem.

It’s worth remembering that new joint stock companies were banned in the UK for over a hundred years following the bursting in 1720 of the South Sea bubble, one of the very biggest financial booms and busts. Adam Smith, who was born three years later, in 1723, wrote of the irreconcilable and fundamental conflicts of interest that occur when there’s a separation of those owning a company from those controlling it.

When new joint stock companies were once again allowed in the UK in 1825, investors in companies’ shares had to carry unlimited liability for losses for another three decades. The 1855 introduction of limited liability was opposed by many precisely because it was felt that this would lead to more reckless behaviour by those running companies.”[The Limited Liability Act] proposes to depart from the old-established maxim that all the partners are individually liable for the whole of the debts of the concern,” said Earl Grey in the House of Lords.

Unfortunately, even though owners carrying unlimited liability should have kept tight reins on those to whome they delegated management duties, they didn’t always exercise sufficient care. Many bank shareholders continued to have unlimited liability until 1879, and when the City of Glasgow Bank failed in 1878 as a result of misjudged speculations in emerging markets, it bankrupted almost all of its stock owners, including John Buchan, grandfather of the famous novelist. The story is recounted by Buchan’s great-great-grandson, James, a former FT journalist, in his excellent 1997 history of money, Frozen Desire.

It's hard to imagine a world more different from the recent "devil take the hindmost" philosophy characterising the behaviour of those running the financial markets.

Principal-agent problems are therefore a recurring theme in financial history, although they’ve reached a new extreme since the mid-1990s. The recent boom in ETFs is in no small part a reaction to excesses in fund managers’ pay policies and the resulting poor value of many investment products.

But investors need to be aware of misaligned incentives, whomever they’re dealing with. As we reported last week, the blurring of the lines between ETF firms and index providers raises some tricky questions over governance. The recurring debates about collateral, counterparty and stock lending risks in ETFs are also, at their heart, expressions of concern about conflicts of interest.

The ETF market has already spawned a few multi-millionaire financiers, but no billionaires of the scale of Soros, Simons and Paulson. But if ETFs are still, fortunately, far from meeting Warren Buffett’s famous description of hedge funds, “a compensation scheme dressed up as an asset class”, there’s also no room for complacency. With reforms bogged down by lobbyists and overshadowed by the debt and euro crises, politicians and regulators are far from addressing the root causes of the agency problems that still beset the whole financial sector.

Price-slashing is in vogue on the UK's high streets, attracting hordes of shoppers from overseas. China's middle classes are snapping up bargains in post-Christmas sales, UK newspapers report.

But the stock and bond markets currently offer poor value by comparison.

In his latest weekly newsletter, fund manager John Hussman estimates prospective 10-year returns on the S&P 500 index at 4.9% per annum, lower than at any time in the last seventy years, with the exception of the period around the technology bubble at the turn of the millennium.

Hussman derives his forward-looking equity market return estimates from the cyclically adjusted price/earnings ratio on the S&P 500 index (also known as "CAPE" or the "Shiller P/E"), which uses an inflation-adjusted, ten-year average earnings measure.

It's clear from the chart below that CAPE has good long-term forecasting power. Back in 1999, when CNBC and investment banks' brokerage arms were preaching rising stock prices to the masses, CAPE predicted negative returns from equities over the next decade: an event that subsequently transpired. Although equities are less expensive now than twelve years ago, they aren't cheap or even fairly valued by historical standards, either.



Source: Hussman Funds

But if 4.9% a year from stocks doesn't sound appetising and won't be enough to plug the looming funding gap at many pension plans, the current yields on bonds are even lower: 2% on 10-year Treasuries, below 3% on 30-year bonds and below 4% on high-quality corporates.

"We presently have one of the worst menus of prospective return that long-term investors have ever faced", Hussman summarises. "The proper response is to accept risk in proportion to the compensation available for taking that risk. Presently, that compensation is very thin."

Hussman's model is one for long-term asset allocators. It has little short-term predictive power, and Hussman admits that in coming weeks and months markets may be poised to rally. However, for a longer-term bullish view on equities to be justified, he says, valuations need to decline further. For this to occur, Hussman suggests, it's important that central banks stop distorting market mechanisms and allow asset prices to find a clearing level, even if that means taking banks into receivership and imposing losses on their bondholders.

"At present," says Hussman, "we have a situation where saving is discouraged by desperately low interest rates, where unproductive uses of capital are not discouraged because the bar is so low, and where central banks recklessly facilitate economic stagnation by bridging the gap between a puddle of unrewarding savings and a mountain of unproductive speculations."  Near-zero interest rates are less the solution than the problem, in other words.

Perhaps 2012 will be the year in which the intensifying standoff between two groups of people comes to a head: those who would prefer to see an end to the use of taxpayers' money in repeated bailouts of the financial system, and those institutions—central banks and the IMF, prompted by incumbent politicians in all Western economies—whose job it seems to have become to prop up asset prices indefinitely.

If government interventions are held back or stopped—perhaps as a result of one of this year's important national elections—and stock prices are allowed to fall to their clearing level then, as Hussman says, "events will unchain the global economy from an irresponsible past and open the gates toward a prosperous future". Amen to that.

According to Lipper, European equity mutual funds have now seen outflows for three years in five, suggesting growing investor disillusionment with this type of savings vehicle.

(See our blog from last week for more details of the Lipper survey)

Though there may also be economic and demographic trends at work, an increasing perception of the poor value of fund management services is undoubtedly causing such large-scale investor withdrawals. With stagnant or falling returns from equity markets over the last decade, the share of those returns being absorbed by costs has gone up sharply.  This is a topic that’s unsurprisingly attracted a great deal of mainstream press attention in recent months.

“3.2 percent in fees are being siphoned off each year from pension plans,” yesterday’s Daily Mail reported.  Investment industry insiders may quibble about some of the measurements used, and many of those attacking fund costs have their own commercial interests to promote, but you can’t dispute the frightening effect of compounding percentage charges in a low-return world.

But it’s not just high-cost active managers who are under fire. Even though ETFs have continued to record net positive sales, the passive funds industry can’t be complacent, either. 2011 was the year in which one of the leading ETF issuers in Europe, Deutsche Bank, admitted in a research article that providers make as much on the side from “ancillary” activities like stock lending, trading and derivatives provision as they do from fund fees.

Other observers have added weight to arguments that you can’t take passive funds’ headline expense claims at face value.  For example, the Bank of England suggested in its summer Financial Stability Report that notionally lower fees on synthetic ETFs may disguise higher and unadvertised risks.

It’s worthwhile remembering the original aim of mutual funds—of which index funds and ETFs are one type. First developed on a large scale in the 1920s in the US, such investment vehicles were designed to offer easy and diversified equity and bond market access to the masses. Open-ended mutual funds became popular after the 1929 Wall Street Crash discredited the previously popular (closed-ended) investment trusts, many of which had become highly leveraged pyramid schemes that ended up losing all their investors’ money.

Reinforced by better post-crash regulation, the US mutual funds industry took off in the 1950s and 1960s, while indexed funds added a formidable new strand to the business from the 1970s, one that continues to gain market share.  The move towards defined-contribution pensions in several Western economies greatly reinforced the demand for such pooled savings vehicles.

Mutual funds haven’t stayed immune from the conflicts of interest that beset the broader financial services industry, though.  Some of the leading names in the business—Strong, Putnam, Invesco, Prudential—were caught up in the 2003 late trading and market timing scandals in the US.  The increasing use by mutual funds of “heads I win, tails you lose” hedge fund-like performance fees is another, more recent cause for concern.

And now, as we have seen, there’s ever more attention to costs and the extent to which the guardians of investors’ money are really working on their clients’ behalf. An increasing number of observers are asking a simple question: why have average fund expense ratios gone up during a decade of poor returns and when computerised trading has greatly decreased the costs of accessing those funds’ underlying investments?

Perhaps a new bull market is around the corner, something that would probably divert attention from nagging questions about fund expenses.  Until then, the extent to which the interests of management companies, fund directors and investors are truly aligned will be the standard by which fund viability should be measured.

Unless the asset management business can address the conflicts of interest to which it seems prone, expect ever more investors to ditch funds altogether and buy equities and bonds directly. Let’s hope that, helped by sensible changes in regulation, 2012 will be a year in which steps can be taken to restore pooled fund investing’s original goal of mutuality.

The increase in the minimum free float required for eligibility for FTSE’s UK index series, announced this week, is undoubtedly a reaction to growing concerns over corporate governance.  FTSE has been careful to appear as neutral as possible in making the rule change: consulting a broad range of clients before increasing the minimum float level, while also making it clear that the consultation process itself came in response to requests from those index users.

As a result of the change, UK-incorporated companies seeking to gain entry to the index provider’s UK index series must have a minimum 25% of freely traded share capital.  Before, a free float of as little as 5% would have been sufficient for some larger-capitalisation companies to gain inclusion in the FTSE All-Share and FTSE 100.

According to a report in today’s Financial Times, the changes haven’t gone far enough for some investors. The UK’s National Association of Pension Funds, which represents funds with collective assets of £800 billion, says that the minimum free float threshold should be set at 50%.  If this higher free float minimum were imposed, says the NAPF, minority shareholders would be able to block a majority shareholder’s resolution (assuming they all voted together).

This response reveals that what appears to be quite a technical issue has much wider relevance than we might imagine. Let’s try to spell out some of the conflicting economic interests at play.

First, FTSE’s role in developing and maintaining indices is not necessarily aligned with the incentives of its new owner, the London Stock Exchange (and the same goes for other exchange-owned index providers). FTSE promises to compile benchmarks objectively and without bias.  Creating the index rules, however, means setting some minimum standards on tradeability.

The LSE, on the other hand, is interested in obtaining revenue from listings and therefore has a natural bias to encourage as many foreign companies as possible to have their shares traded in London.  The UK regulator, the UK Listing Authority (UKLA), has also so far taken a liberal view on listing requirements, presumably because it takes a similar view and wants to encourage companies to shift their headquarters to the UK.

“Isn’t it odd that FTSE now sets a higher minimum free float requirement than the regulator?” Mark Makepeace, FTSE’s chief executive, was asked on a conference call yesterday by a journalist.  “You should ask the UKLA,” Makepeace responded.  Makepeace also insisted that FTSE’s policy committee, which sets index rules, will remain completely independent from the LSE.

Second, there’s an obvious conflict between the interests of companies looking to gain index access and attract capital from the growing pool of tracker funds (i.e., to sell their shares for as high a price as possible) and the interests of investors buying those funds (who want to buy as cheaply as possible).

Whether or not a small free float contributes to greater potential price distortions as a result of index inclusion is an important additional question, and a difficult one to answer. In principle, the free float adjustment which most index providers now use as standard (reducing the weight of a company in the index by a factor reflecting the proportion of that company’s share capital that is not traded) counteracts the natural supply/demand imbalance that would occur if you had a lot of index funds chasing a small number of liquid shares, forcing up prices.

On the other hand, the lower the absolute level of free float, the greater the chance of “accidents” occurring, even if indices are adjusted to reflect the number of their constituents’ shares that are tradeable.  This is particularly true when changes in economic interest can easily be conducted behind the scenes and via derivatives contracts. The massive short squeeze of 2008 in Volkswagen shares, which severely distorted the DAX index and which involved both a small float and derivatives-based buying, is an obvious case in mind.

It’s important not to be naive about companies’ motivations for wanting index inclusion.  Of course they want to boost their share prices, even if only on a temporary basis (to allow some shareholders to cash in).  And it’s not just a question of nefarious oligarchs from the former USSR seeking access to the pool of capital widely tracked indices can guarantee, even if that makes good headlines and many companies  from that region cite this as a key motivating factor for listing in London.

Given the importance of passive investing, while index providers go to great length to compile benchmarks that can actually be tracked, they do not provide any assurances about the quality of the companies they are admitting, something it’s easy to forget. Remember Polly Peck, Maxwell Communications, Baltimore Technologies, Marconi, or RBS? All are one-time FTSE 100 companies that soared and then crashed.  The fund managers buying those companies and getting burnt were the ones at fault for not doing their homework, not the index provider.

But passive investors are unable to make judgement calls of this type, since they buy all the index shares as a matter of course.  Those investors should take particular care, in other words, and not just buy index funds or ETFs blindly because they appear cheap on a headline basis.  The portfolio of shares or bonds you’re accessing via an index should make sense as an investment in its own regard.  You mustn’t let the index tail wag the fund management dog.