The Low Growth, Low Return World and

What It Means for the Rise of Passive Investing & Smart Beta

Jay Pelosky Founder & Principal J2Z Advisory LLC

Pelosky.com

 

THE UPSHOT

Low Growth > Low Returns > Rise of Passive > Smart Beta & Robo Advisory = Opportunity.

GLOBAL GROWTH DECELERATION

• Potential Growth Rates 1990s 2016 US 3.3% 1.75% DM 2.25% 1.6%

• US & EU Natural Rates of Interest = 0% (Real Rate that Balances Monetary Policy so it is Neither Accommodative nor Contractionary).

KEY GROWTH INHIBITORS

oPoor Demographics In Both Developed & Emerging Economies – Getting Old Fast.

oDeclining Labor Productivity – US in Biggest Slump Since the 1970s. World Productivity has Collapsed from 1.8% to 0.5% pa.

KEY ECONOMIC TAKEAWAYS

o Low Growth World is Here to Stay Over Foreseeable Future (3-5 yrs.).

o Declines in Potential Growth Rates & Natural Rates of Interest are GLOBAL.

o Drivers are Powerful, Long Term Factors that are Unlikely to Reverse Quickly.

POLICY SOLUTIONS?

Monetary Policy oOverused oRise of the Big Fear?

Fiscal Policy oUnderutilized… Like Waiting for Godot BUT oThe Wait May Be Over: Tricky Transition to

Joint Monetary – Fiscal Policy Ahead

THE LOW RETURN WORLD - PENSIONS

o US Public Pension Fund Target Return = 7.5%

o US Public Pension Fund Actual Returns

Last 20 Years = 7.2% Last 10 Years = 5.8% Last 1 Year = 0.3%

o US Economy in 7th Year of Economic Expansion. US Stocks and Bonds Close to All Time Highs in Price & Valuation. What Happens to Returns when the Next Recession or Bear Market Hits One or Both Asset Classes?

THE LOW RETURN WORLD -MILLENIALS

o Bigger Cohort than Baby Boomers.

o Good News: Open for Business, Like to Save (Over 50% Allocation to Cash).

o Bad News: Distrust Experts & Elites, Fee Averse.

SEA CHANGE AT HAND

Baby Boomers: Gen Mutual Fund

Millennials: Gen Passive

ASSET MANAGEMENT LANDSCAPE

oPensions: $35 T oMutual Funds: $11T oETFs: $3T oHedge Funds: $3T oRIAs: $2T oSmart Beta: $575B oRobo Advisory: $19B

ASSET MANAGEMENT LANDSCAPE

o Passive = 40% of US Equity Fund Assets and 25% of US Fixed Income Assets for Total of 30% of Total Public Assets.

oWhat is the Prospect for Passive to = 50% of Total Public Assets by 2020?

o Pretty Good at $1T shift pa ($500B out of active and $500B into Passive).

THREE MAIN CHANGE AGENTS

o Passive Option Exists Globally & in All Parts of the Market.

o Technology Drives Fee Transparency. o Poor Active Management Performance (88%

Underperform S&P Past Decade). o END RESULT: Rapid Erosion of Active Manager

Monopoly Pricing & Rising Appeal of Passive.

ACTIVE MANAGEMENT UNDER THREAT

Active Management Under Pressure from

Top

Down Pension Fund Community & Bottoms

Up

Via the Rise of the Millennial Investor.

ASSET MANAGEMENT BOTTOM LINE

Expensive & Underperforming in an Age of

Fee

Transparency & Passive Options is NOT a

Recipe

for Success or Longevity.

THE RISE OF PASSIVE

o Cost: a Leading Predictor of Performance

o Average US Equity Mutual Fund Fees = 125 bps vs. Average US Equity ETF fees of 15 bps.

o In the Low Return World Every Basis Point Counts.

THE FUTURE OF PASSIVE IS BRIGHT

o Pension Fund Globalization & Migration to Passive

oMillennial Adoption

o Fixed Income Expansion

o Regulatory Encouragement (DOL Fiduciary Ruling)

SMART BETA

o Long Academic History: Quant, Rules Based, Transparent, Repeatable & Scaleable.

o First Multi Factor ETF Launched a Decade Ago.

o First Min Volatility ETF Launched in 2011 (though most would say 6 months ago).

SMART BETA

o Rules based Tilts: Quality, Momentum, Value, and Volatility

o A Blend of Active (tilt) and Passive (Index based)

o Adoption Driven by Search for Edge in a Highly Correlated, Highly Uncertain World.

MIN VOL & THE FABLED FREE LUNCH

YTD LTM USMV 9% 13% SPY 6% 9%

EUMV -1% -1% FEZ -3% -8%

JPMV 6% 10% EWJ 2% 4%

EEMV 10% 4% EEM 15% 8%

MIN VOL BEYOND THE FREE LUNCH, AKA DESSERT

o Reduce Drawdown Risk, Minimize Fee Pressure

o Avoid Market Timing Challenge

10/08 3/00 SPY -17% 10%

Av Investor -24% 4%

MIN VOL FEARS: EXPENSIVE, OVEROWNED, A BUBBLE?

o Expensive? Yes, it should be in a low growth,

low return world characterized by sharp

drawdowns.

oOver-owned? Don’t Think So. Two Main Min

Vol Products Have Net Assets of $23B vs. SPY

Net Assets of $200B. YTD Inflows to Min Vol =

$16B; total Inflows to Passive = $400B.

MIN VOL BUBBLE TEST

If Min Vol Underperforms The S&P During The

Next 10-15% Pullback Then Bubble Believers Will

Have a Case.

MILLENIALS: INVESTORS OF THE FUTURE

o Characteristics Include: Technology = Mothers Milk.

o Veterans of Both 9/11 and the GFC = Deep Aversion to Permanent Loss.

o Little Trust in Elites or Experts.

o High Savers, Cash Hoarders.

THE ROBO OPPORTUNITY

oMillennial Investment Vehicle of Choice.

o Booster Rocket for Passive.

o Potential Growth From $19B AUM to $500B in 5 Years!

FOUR DRIVERS TO THE (PASSIVE) FUTURE

o Continuation of the Low Growth, Low Return World

o Sustained Focus on Fees & Performance

o Pension Fund Revolution

o The Rise of the Millennial/Robo Combo

THE BOTTOM LINE

The Investment Opportunity of a Lifetime: A Fully Loaded, Passive Tool Kit that Allows One to Create Low Cost, Liquid, Transparent, Global, Multi Asset Portfolios that Employ Rules Based Factor Strategies Delivered via Robo/Hybrid Investment Platforms to Meet the Investment Needs of Asset Owners & Millennials Alike.

WINNERS & LOSERS

WINNERS  o Passive/Smart Beta o Robo Advisory o ETF Strategist/Model Portfolio o Asset Allocation Specialists

LOSERS o Active Managers

o Legacy Buy & Sell Side o Hedge Funds/Liquid Alternative Strategies o Research Analysts