ETPs, ETFs – WTH?! KCS’s February Fireside Chat

ETPs, ETFs – WTH?! KCS’s February Fireside Chat

We are pleased to share with you KCS’s February 2014 Fireside Chat.  This article is related to “ETFs”.

…What’s the Hype?!


As philosopher Jose Marti once said, “Like stones rolling down hills, fair ideas reach their objectives despite all obstacles and barriers.  It may be possible to speed or hinder them, but impossible to stop them.” So goes the growth in Exchange Traded Products (ETPs)! Although ETPs have been around since 1993, the growth in these investment products has been startling during the last decade, and especially in the last five years.  On a global basis, it is estimated that there exist more than 4,700 ETPs from more than 200 providers with assets exceeding $2.1 trillion and traded on 56 exchanges. Wow! 


Please click onto the link to gain access to the entire article.


China’s First WMP May Not Default on the 31st, but …

We may not witness the first default of a China WMP on January 31st, as it appears that a “plan” is in place to repay those that contributed, but the rescue may create a moral hazard that will only exacerbate future problems with WMPs.

Here is the latest news out of China courtesy of Quartz.

In ICBC they trust

The $469 mln bailout of this investment product risks inflating China’s shadow banking bubble even more



As we wrote last week, the fate of China’s $5 trillion shadow banking system has been hanging on a $469-million investment vehicle that looked in danger of defaulting at the end of this month. Today, reports Bloomberg, a solution seemed to appear, when Industrial and Commercial Bank of China (ICBC) told investors that they would be able to recoup the money they had put in by selling to “unidentified buyers.” (Caixin reports that ICBC, the Shanxi provincial government and the trust company, China Credit Trust, have located a strategic investor (link in Chinese) who will buy the rights to the WMP from customers.)



But the news raises as many questions as it answers, and sets a dangerous precedent.



The investment, a wealth-management product (WMP) called “Credit Equals Gold #1,” was being used to finance a loan to a coal company gone bust. For ICBC to bring in new investors to take it over is a bad precedent for two reasons: First, it’s widely assumed that loans made in this way are guaranteed by the government. Second, people generally see their WMP investments functioning like higher-yield deposits—the way people in the West might keep cash in a money-market fund instead of in their checking account—implying that they’re free of risk.



Those assumptions are behind the reckless inflation of China’s shadow credit, which David Cui, economist at BofA/Merrill Lynch, calls “one of the biggest moral hazards in the financial market globally in recent years,” in a note published earlier today.



The outcome of Credit Equals Gold #1 was the big test-case for these assumptions. By mollifying customers, ICBC and the other parties involved risk making this moral hazard much, much bigger.



In all fairness, the alternative was likely to be much more painful in the short term. WMPs put banks in a tough spot. Letting customers swallow the losses would force all of China’s WMP customers to “see clearly the risks,” as Jiang Jianqing, chairman of ICBC, put it on Jan. 24. And that might deter people from investing in WMPs—a dangerous thing for banks, which see WMPs as a vital source of profit growth.



​Responses to an online survey conducted by Sina Finance on behalf of CITIC, which also sells WMPs.


It also would have come at a risky time, given that money is unusually tight in the run-up to Chinese New Year (which falls this year on Feb. 1), and especially right now because jitters in Argentina and Turkey in the last few days have made emerging-market investors nervous.



Reassuring customers that their investments are guaranteed means shadow bank funding will continue for now. But at some point soon the central government will need to confront the moral hazard bailouts create. Demand for credit is surging, as you can seen in the chart below. That might be due to the combination of banks’ year-end scramble to meet cash requirements set by regulators as well the typical uptick in demand for money just before Chinese New Year.



BofA/Merrill Lynch


But as BofA/Merrill Lynch reports, the pace of defaults on trust loans is picking up (here’s just one example of that trend). More than 100 billion yuan ($16.5 billion) in mining-related trust loans alone come due in 2014—and given that falling coal prices are throttling profits, many of these companies will struggle to come up with that cash.


That means regulators will have to address the moral hazard problem soon, at which point “things may get ugly rather quickly,” writes Cui. ”After all, the stability of the shadow banking sector is based on public confidence and we all learned from the subprime crisis that confidence is a fickle thing when the ground below is crumbling.”

Might January 31st Be A Day Of Reckoning for China’s Banking System?

Thanks to Mark Grant, I became aware of a potential financial issue facing China’s banking system.  It seems that China’s banks have created products with inflated “promised” yields in the 5%-8% range.  Here is an article from International Business Times on WMPs.  One of these WMPs has already informed their investors that they may not have the cash to pay them back on January 31st.  The product needs to repay investors nearly $500 million, and the ramifications from a default could send shock waves through the global markets.


“Legally they [WMPs] are not deposits. They are investment products that are managed ‘off-balance-sheet’ by banks, and there is little transparency about where the funds are going,” said Stephen Green, head of Greater China research at Standard Chartered in Hong Kong, in a note.

According to Green, the funds from different WMP products are often mixed and deployed to finance a broad pool of assets that more often than not fall into the sectors of the economy that regulators have attempted to fence off from normal bank lending (real estate, local government infrastructure, etc.), partly because these sectors are deemed to be particularly risky. In addition, the banks hold neither reserves of WMP deposits nor capital against the assets.

The yields offered on these WMPs usually stand at around 5.5 percent, compared to about 3.3 percent for a traditional one-year deposit.

Newly issued WMPs with 5 percent per annum “promised” returns reached a record high over the past five weeks, according to David Cui, head of China Equity Strategy at Bank of America Merrill Lynch.

number of wmps issued A growing number of newly issued WMPs are offering annual returns within the 5-8 percent range.  BofA Merrill Lynch Global Research

Over the past five weeks, 83 percent of WMPs sold have an expected return of 5 percent to 8 percent, compared to an average of 32 percent in 2013 and an average of 46 percent since May end.

percentage of the number of wmps issued The percentage of newly issued WMPs that offer higher return has risen significantly over the past year.  BofA Merrill Lynch Global Research

Xiao Gang, chairman of Bank of China (SHA:601988), one of the top four state-owned banks, said in an October 2012 op-ed published in the English-language China Daily that many assets underlying the WMPs were dependent on real estate or long-term infrastructure projects that might find it impossible to generate sufficient cash flow to meet repayment obligations on short-term WMPs.

To avoid a crisis, banks issue new WMPs to repay existing subscribers, creating a “Ponzi scheme,” Xiao said.

Outstanding WMPs in banks totaled 9.08 trillion yuan ($1.64 trillion) at the end of September 2013, according to the China Banking Regulatory Commission. Green expects this number to go up to 11 trillion yuan at year-end 2013.

“The U.S. Pension Crisis”

Congratulations to Ron Ryan, CEO at Ryan ALM, on the publishing of his book titled, “The U.S. Pension Crisis”.  Ryan’s book articulates what needs to be done NOW to save America’s pensions. 

When testifying before the ERISA Committee in 2003, Ron highlighted the issues related to GASB and FASB accounting rules, and the distortions to contributions, funded ratios, earnings and balance sheets brought about by their failings.  This book is a must read for anyone who truly wants to understand why our defined benefit plans are in such a state right now.

Asset Consulting Firms and Their Consultants Aren’t Commodities

The environment for asset consulting firms is quite challenging.  Historically, there have been few barriers to entry, and measuring the value-add provided by the asset consulting firm has been difficult to gauge.  As such, hiring decisions have often come down to price, with the low bidder more often than not winning the assignment.  For those firms fortunate to be given an assignment, the life cycle of the relationship is generally fairly long (about 7 years), as it usually takes a departure of the consultant or a major screw up before the relationship is terminated.  This practice has to change.

Given the current state of defined benefit plans in the US and abroad, this is not the time to fiddle while Rome burns. It is imperative that asset consultants be judged for the value that they bring to a relationship, and they should be compensated based on that value-add.  There are many services that consultants provide, but the importance to the success or failure of a plan varies widely.  Establishing the right plan benchmark is critical, and it isn’t the ROA. We believe that it should be the plan’s specific liabilities. The investment structure and asset allocation that flows from a greater knowledge of the liabilities are key decisions that drive most of the plan’s subsequent return. However, it seems to us that most of the time (80/20 rule) is spent on trying to identify value-added managers. Get the wrong asset allocation and the best performing managers in the weakest asset class won’t help you much.

Let’s see if the industry can refocus on the importance of DB plans, so that we can stabilize the retirements for both our private and public workers.  As such, let’s begin to evaluate consulting firms that can improve the funded ratio and funded status, while minimizing contribution costs. These are the important metrics when evaluating a consulting firm and their consultants.  Experience matters in this industry.  We pay great homage to it on the asset management side of the business.  Why isn’t this as critical when evaluating asset consultants?  Remember: asset consultants have a greater impact on your plan than any individual manager does!

KCS told you this 15 months ago

KCS told you this 15 months ago

Mr. Bernanke said recent government spending cuts and tax increases have worked against the Fed’s efforts to encourage more spending, investment and hiring.
“With fiscal and monetary policy working in opposite directions, the recovery is weaker than it otherwise would be,” Mr. Bernanke said, stepping up arguments he has made about recent government efforts to reduce near-term budget deficits.

These comments were taken from the attached WSJ article from January 3, 2014

This article was brought to my attention by my son, Ryan, who also reminded me that KCS had reported nearly 15 months ago that the fiscal drag created by both deficit reduction and tax increases would combine to damp economic activity and the recovery from the great recession.  Economists estimate that the US economy grew in 2013 at roughly 2.1%, which is very modest given this many years into the “recovery”. 

As a reminder, KCS produces a monthly investment article on a variety of topics.  In addition, we occasionally produce a piece titled “Burning Issues”.  In the October 2012 Fireside Chat, and again in the January 2013 Burning Issue, we highlighted the potential drag from fiscal tightening.  Both articles are available on the KCS website at

GDP= C+I+G+(X-M), where C=consumption, I=Investment, G=government spend (deficit) and X-M=net exports

The consumer has been, until recently, reworking their balance sheets, and have reduced debt to roughly 92% of earnings. Corporate investment has been tame, but appears to be growing at a faster pace, and this should continue through 2014.  Net exports remain a large drag on GDP, but trade imbalances have improved.  The fiscal deficit has been cut nearly in half through spending cuts and tax increases.  We are unlikely to see greater fiscal cuts in 2014, so the drag on GDP may be lessened.

We, at KCS, are expecting GDP growth to be slightly greater than current forecasts (2.7%).  In fact, it would not surprise us to see GDP growth exceed 3% – 3.5% in 2014. Our hope is that greater investment will continue to strengthen the US labor market, increasing wage growth and spurring demand for goods and services. If this scenario materializes, our GDP forecast may be understated.