ETF 2.0 : Mega-Blockchains

ETF 2.0 : Mega-Blockchains

Salutations dear reader from your ‘Suitcase Fund Analyst’, your humble observer of the periphery, the future and dysfunctions of asset management. As I travel far and wide to debate the prospect of ‘digital death’, recent events have taken me to Dubai and Hamburg. Yet no matter where I go, a common theme follows me - digitalisation, robotisation, artificial intelligence. The New Fund Order I wrote about in my book in 2015 is unfolding quickly, first in academia, then notable authors, then popular media, then event organisers, asset managers, distributors and eventually the common variety fund investor (ahem).

The very phrase ‘2.0’ has become synonymous with this period of change, the 4th industrial revolution, it is as prolific now as ‘hashtag’. Indeed my very own ‘#NewFundOrder 2.0’ was an attempt to capture the mood, moving beyond the dysfunctions of the Old Fund Order and focussing more on Fintech solutions that offer fund buyers a means for survival, indeed even resurrection.

Thanks to subsequent conversations I now even lecture on the impacts of artificial intelligence on funds and fund selection, digitalisation for me has taken on a very personal aspect in my working life. The fact I have seen well over 2000 fund managers in my time, like many, is rapidly becoming superfluous. My life is now split between Fintech and fund investing. Indeed as time goes on, in the space of only two years I may become more remembered as the guy who foretold the impact of digital on fund selection than being a fund selector for the best part of two decades. Whether I am talking about clones, drones or tombstones, Godzilla or the Orwellian Human condition, the digital frontier is not far away.

On the flight out to Dubai I watched again Trainspotting 2 or ‘T2’ for short. Irvine Welsh’s great contribution to modern culture and post pop, post Brexit, post Devolution Scottish vernacular. Euan McGregor’s character ‘Renton’ especially is the embodiment of post revolution dystopia, resistance giving in to resignation that the human condition is flawed but time is inescapable:

Choose Life: “Choose Facebook, Twitter, Snapchat, Instagram and a thousand others ways to spew your bile across people you've never met. Choose updating your profile, tell the world what you had for breakfast and hope that someone, somewhere cares. Choose looking up old flames, desperate to believe that you don't look as bad as they do. Choose live-blogging, from your first w**k 'til your last breath; human interaction reduced to nothing more than data.”

Welsh’s cynical futility of social media overlooks the significance to how we can interact, becoming ever more trusting of electronic social platforms over traditional sources of wisdom. Social media is only one part, the dematerialisation of everything into the blockchain coupled to advances in Artificial intelligence question not only capital models but human productivity itself. We head furlong into a Ridley Scott dark futurism of cybernetics and humans struggling to co-exist in 2049 or perhaps even becoming symbiotic ourselves, not human, not machine but a ‘Ghost in the Shell’. Do we want to be the blade-runners, the humans or the machines?

Having been heavily influenced in 2015 by Martin Ford’s book ‘Rise of the Robots’, Mrs JB bought me a new book ‘Life 3.0’ by Max Tegmark. The tagline ‘Being human in the age of Artificial Intelligence’ aptly describes the acceleration in the possible, as he notes: “Will AI help life flourish as never before, or will machines eventually outsmart us at all tasks, and even, perhaps, replace us altogether?”

So too then must our asset industry change. Moore’s Law is unwavering in this respect and no industry gets away Scot free. It has been in a stupor of old business models, commission, star manager culture, asset concentration, marketing, high costs, low transparency, lavish hospitality and poor fund selection. Asset management is beginning to detox from those heady party days. The party is over but for now the masses remain sedated on the methadone of vast market cap weighted Exchange Traded Funds (ETFs).

The reality is that ETFs also face issues, capable of so much more than how they are being used today, they have been held back by a simple presumption that pooled investing is about cramming masses into a single model yet somehow each trying to derive their own utility from it. Clearly it hasn’t worked, trust in asset management and active managers has never been lower, herding patterns are accelerating, as are the daily trading volumes of index products. The optical value of ETF has become a blunt question of only cost. A huge mistake but one being driven by the index manufacturers and misplaced academics and pundits. Perhaps in their minds they chose the lesser of evils. What started as disrupter is now supposed deliverer.

However concern turns to the asset concentration building among ETFs, as a result of using outdated index construction. In simple terms the pooling of vast uncontrolled open-ended structures, funnelled into controlled closed-ended securities, is a recipe for Minsky-like commodity bubbles. Earnings then do not drive price, the order book does, the equilibrium between buyers and sellers. This is an index anomaly and a missed opportunity for ETF. Before you may recall I have written about Tesla, how ETFs might evolve and take lessons from the Automotive industry and Electric Cars. I am now even more convinced that we are only at the beginning of ETF evolution. Fully dematerialised fund structures are the future, all others will become obsolete. It is no coincidence that active asset managers are rapidly buying ETF businesses, the potential for active intellectual property through ETFs is huge. This might be summarised as the move to ‘Smarter-Beta’ or codified Alpha.

However I believe ETFs will go much further in the future. I have already begun to structure and codify what ‘ETF 2.0’ might look like. It will form my next lecture at Fintech Circle Institute. A complete rethink of how ETFs operate, in 2.0 investors will have individual pathways, cross-matching assets for expected return, risk, time horizon and maturity, investors trade through Blockchain within the ETF, fully dematerialised, frictionless trading between investors. The key aspect here is the simultaneous checking of the asset pathway, individual pathway and block pathway - I call this your Asimov test. ETF 2.0 will allow;

• Manage individual investor pathways: for a large neural system, managing thousands of unique investors is achievable with bespoke journeys, targets, risk tolerances within one ETF,

• Combining automated client risk utility with asset allocation, algorithmic trading, and multi factor systematic investing attune to each investor,

• Statistical Arbitrage: identifying anomalies within the market, within and outside of the ETF and exploiting them continuously, such algos can also be used to monitor any behavioural anomalies between matches trades or investors within the ETF or the market,

• Restructuring the pooling of the ETF to assign stocks to match different investor time horizons and risk tolerance, moving us away from a one-basket-fits-all mentality that has underpinned ETFs to date,

• Investors may even be able to interact within the block, commingling wisdom of the crowd, the frameworks needed already exist in the likes of Crypto currencies and Differentiable Neural Computing like AlphaGo.

Tech is full of jargon but safe to say that Blockchain provides us the necessary infrastructure and AI the ability to manage it once created. The ETF becomes the centralised clearing agent for all of its investors and trades within the ETF allowing; instantaneous transparent straight-through-processing (STP) and delivery-versus-payment (DVP), investors still benefitting from novation, fully dematerialised fungible assets and economies of scale (as with current ETFs) but now investor trades are matched inside the ETF not simply pooled and traded outside on the market. It would make the investors within an ETF a complex adaptive community, trading as a block with the rest of the market. Meanwhile ETF 2.0 would communicate continuously with other ETFs, exchanges and trading platforms to ensure correct real time pricing. Everyone shares in the success of the ETF, assets and returns weighted to their individual pathway and maturity. The ETF provider deducts one disclosed cost to administer the algorithm, the trades and investors. While this may feel quasi-ponzi to some; this is no fugazi. The quandary left behind by Madoff (other than his conceit, deceit and fraudulent behaviour) was that the biggest failing of any ponzi is the incorrect estimation of cash flow and matching of assets over time. Eventually they run out of cash. The concept of cash matching individual investors is itself well supported by liability driven investing. The technology to match thousands of individuals has been beyond us, until now.

Once an ETF is repurposed for individual pathways; rather than aggregated pooled outcomes, then assets are coded for cost, time and risk-matched to investors who need them. ETF 2.0 can trade internally, frictionless through block-chain technology, within the ETF and then only traded externally with the market when in net surplus of cash or assets. In effect we can create mega-blocks of investors, providing efficiencies in turnover costs and accurate investor-matched, risk-targeted allocations. This re-design of mutual investing would require a complete re-think in how asset management is structured today: advisers, fund managers, fund investors, custodians, exchanges and clearing houses.

Digital frontier? Suddenly Passive becomes social, benchmarks become meaningless, replaced by block economies. In the GRID we can each view our own pathway to maturity in augmented reality from the comfort of our own home or on the move. Effectively we would create a different pooled model and we haven’t even begun to think about quantum computing and isotopic algorithms and a hundred other cool bits of jargon that few of us properly comprehend. Science fiction is rapidly becoming a near term indication of science fact, the lines are blurring. To some this may sound like the onset of techno-Marxism on asset management, for others its salvation. I will explore the concept in detail in my lecture and invite ETF innovators and coders to come together and create ETF 2.0.

As Jeff Bridges (Flynn) said in the film TRON Legacy, ‘Digital Jazz man…..’