What’s Next for ETFs

By Crystal Kim

“The innovation around ETFs means you can now trade all sorts of things most individual investors never wanted to trade.” —DAVE NADIG
“The innovation around ETFs means you can now trade all sorts of things most individual investors never wanted to trade.” —DAVE NADIG Photo: Matt Furman for Barron's 

No invention has been more disruptive to the asset-management industry in the last quarter-century than the exchange-traded fund. Its tradability, tax efficiency, and cost ignited the low-fee revolution, sapping assets from actively managed mutual funds and fundamentally changing how advisories, brokerages, and asset managers conduct business. Just as the smartphone led to more innovation—interactive maps, ride-hailing apps, and social media—the ETF has created liquidity in hard-to-trade asset classes, enabled price discovery during trading halts, and delivered strategies previously reserved for institutions to the investing masses.

As the ETF industry matures—it now has $3 trillion in more than 2,000 products—Barron’s convened a panel of experts to discuss what sort of innovation investors can expect next: Ben Fulton, CEO of Elkhorn Capital Group, who just sold his $217 million ETF strategist firm to Turner Investments; Corey Hoffstein, co-founder of Newfound Research, the quantitative asset-management firm; Dave Nadig, CEO of research and data provider ETF.com; and Barry Ritholtz, co-founder and chief investment officer of Ritholtz Wealth Management, which oversees $607 million, 44% of it in ETFs. They are innovators—Fulton, the architect, created nontraditional benchmark indexes; Hoffstein, the quant, built algorithms designed to time major market moves; Nadig, the philosopher, offers opinions that are widely quoted; and Ritholtz, the investing sage, has guided the public through market peaks and valleys.

Barron’s: People in the ETF industry love saying two things: That ETFs are innovative, and that ETFs are a technology. How is the first true, and what does the second even mean?

Dave Nadig: ETFs are fundamentally a technology. They are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package. The ETF structure, the technology itself, is straining to do all the things that we want it to do. People want ETFs to be like mutual funds.

Trying to shoehorn nontransparent active management into an ETF is the easiest case in point.

Barry Ritholtz: Innovation is all about asking, “What is less than ideal, and how can we find ways to solve it?” ETFs have solved many problems in the world of investing.

Corey Hoffstein: ETFs are innovative in that they trade more efficiently, but most financial advisors say the real benefit is the tax deferral for long-term investors. [Mutual funds often distribute capital gains that fund investors, even if they don’t sell their fund shares, must pay a tax every year; ETFs generally do not distribute gains.] ETFs cost much less, because ETF providers don’t have to pay platform fees. Most brokerages charge a variety of platform fees for mutual funds, including distribution fees and service fees. All of that ended up being an incredible solution and improved everyone’s circumstances.

Ben Fulton: Technological innovations go through cycles, and ETFs are no different. The ETF was a structural innovation. Then came index innovation, with cap-weighted, equal-weighted, float-adjusted-weighted ETFs—the list of new ways to build an index goes on. That drove product expansion. Now we’re seeing distribution innovation, also known as the Charles Schwab [ticker: SCHW] story. They created their own family of fundamentally weighted ETFs in 2013, and the firm in no time gathered $90 billion in ETF assets. That’s the evolution.

Of course, innovation can come with its own problems.

Ritholtz: Jack Bogle has hated the idea of ETFs because he thought it was going to encourage people who should be long-term investors to become active traders. I don’t know how accurate that fear has proved to be.

Nadig: It’s true that the innovation around ETFs means you can now trade all sorts of things most individual investors never wanted to trade. My mom can now buy long-dated oil futures, because ETFs democratized access. It puts a bigger onus on caveat emptor: Buyer beware. But it has also enabled entire businesses like Newfound to use ETFs as vehicles for a larger investment objective. In the hands of uneducated individuals, they can be a problem. ETFs are extremely sharp tools in the drawer.

Fulton: Mutual funds sell the concept of “once you buy this fund, you can own it the rest of your life and we’ll take care of the rest through all market cycles.” None of us built ETFs that way. Exposure to emerging markets and high-yield bonds—there’s a time you want them, and there’s a time you don’t. Do you think you are going to own the iPhone 7 for the rest of your life? It is going to be replaced. There will be new options.

Ritholtz: We’re in the middle of this Cambrian explosion of new ideas, some of which will work out splendidly, and some of which will crash and burn spectacularly.

That doesn’t sound like great news for investors.

Ritholtz: There are products the investing public should want but doesn’t know it yet, and there are things it wants but Wall Street doesn’t know it yet. I love what Jeff Bezos said—if we are not failing, we are not trying enough new and innovative things. Most companies don’t know how to fail, so it is left to the marketplace to decide. We should be throwing a lot out there. It should be responsible—I don’t think we need a 10X-leveraged Bitcoin ETF. But we certainly should be trying new and different ideas. That Darwinian process of natural selection is ultimately going to lead everybody to a place where the menu is full of attractive options.

“Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations.” —COREY HOFFSTEIN
“Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations.” —COREY HOFFSTEIN Photo: Matt Furman for Barron's 

As someone who uses behavioral finance in his practice, you know people get overwhelmed by an extensive menu. How do they choose?

Ritholtz: Ask the waiter. Really, there is something to be said for the wisdom of the crowd. It’s not a coincidence that the SPDR S&P 500 [SPY] is the largest ETF.

Nadig: There are more than 2,000 ETFs and 9,000 mutual funds, and just 3,500 stocks, in the U.S. There is nothing magical about the ETF structure that makes an investment decision any easier, except that it gives investors access to more types of assets and lowers costs. But you have to understand what you’re investing in. A triple-leverage inverse S&P 500 ETF can be a very efficient hedge for an insurance company. But if my mom is investing her retirement in it, that’s an inappropriate use of that product.

Where would you like to see more innovation?

Fulton: We need more high-conviction, concentrated stock ETFs.

Ritholtz: My big beef on the product side has been environmental, social, and governance, or ESG, investing. In major ESG indexes, the top holdings— Microsoft [MSFT], Procter & Gamble [PG], Merck [MRK], Coca-Cola [KO]—are all well-regarded giants under the green umbrella, often in the consumer, tech, and pharmaceutical sectors. So you get a variation of the Standard & Poor’s 500 or some other broad index. My office created a set of ESG portfolios that are variations of our core portfolios because clients demanded it. This is one area where the mutual fund industry is still far, far ahead of the ETF industry and there is unfulfilled demand.

I want a concentrated ETF full of investments that can actually move the needle. Monsanto [MON] is being acquired, so it’s not a great example, but it and other companies developed drought-, salt water-, and stress-tolerant corn, soybeans, and wheat. That’s huge for farmers. They don’t call it impact investing for nothing.

Nadig: The reason for that is active management. That’s changing slowly; companies like MSCI now have a huge ESG data set people can build indexes off of. Sustainalytics is another. We have some of those products now, but the mutual fund industry has had more runway to make that happen. There is a specious argument about whether indexing flummoxes activists from extracting value from companies. Just because an investor is passive doesn’t mean he or she doesn’t have opinions.

Ritholtz: There is demand, especially among millennials, from people who want their money to reflect their values. Rational homo-economist-type people think of investing as utilitarian: I invest my money so when I retire, my standard of living doesn’t drop. In the real world, real people don’t think or behave that way.

Hoffstein: ESG investing isn’t going to help people retire better. Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations. The innovation needs to be around efficient use of capital.

Instead of an ETF that holds intermediate-term Treasuries, I would like to see a U.S. Treasury ETF that uses Treasuries as collateral to buy S&P 500 futures, so you end up getting both stock and bond exposure.

That sounds like the equivalent to the 130/30 mutual funds that were so popular in the mid-2000s. Those funds shorted as much as 30% of the portfolio.

Hoffstein: By introducing a modest amount of leverage, you can take $1 and trade it as if the investor has $1.50. After 2008, people became skittish around derivatives, shorting, and leverage. But these aren’t bad things when used appropriately.

“The challenge for every advisor today is to explain what their value-add is, because the portfolios are, if not free, cheap.“ —BARRY RITHOLTZ
“The challenge for every advisor today is to explain what their value-add is, because the portfolios are, if not free, cheap.“ —BARRY RITHOLTZ Photo: Matt Furman for Barron's 

Nadig: There is a ProShares Large Cap Core Plus ETF [CSM], which tracks the Credit Suisse 130/30 Large Cap Index. There is always a cost and always additional risk for that excess return. My concern is that we are starting to get down to very narrow exposures.

Do you mean overly specific ETFs?

Nadig: We’ve had a lot of ETF launches recently—38 in the past month alone—and part of the reason is because people are still trying to motivate investors to slice their portfolios up into chunks. The world’s most boring portfolio is VT, or the Vanguard Total World Stock ETF.

Most mom-and-pop investors would be well served by a one-, five-, or six-ETF portfolio. They don’t need 2,000 to get diversified.

Professionals are putting ETF portfolios together in innovative ways—combining active and passive to meet a specific objective.

Hoffstein: Most major ETF providers offer their own allocation model for free, but those models are filled with their own products. Newfound takes a multimanager approach. We have a portfolio that aims to provide diversified asset allocation with lower risk and includes JPMorgan Diversified Return U.S. Equity [JPUS], which tilts toward value and momentum; iShares Core U.S. Aggregate Bond [AGG], one of the lowest-cost core-bond ETFs you can get; as well as our own Newfound Multi-Asset Income mutual fund [NFMAX]. We want low-cost access to U.S. stocks, and we want to key in on factors that can produce better returns over time. We also include the AQR Managed Futures Strategy fund [AQMIX] for crisis-type situations. It helps us manage risk because it can short asset classes around the globe. The Newfound fund is designed to provide a variety of different alternative income sources such as high-yield bonds, bank loans, and emerging market debt, but in an actively risk-managed manner that allows us to move the portfolio to short-term Treasuries if there is significant risk of loss.

So none of you see a problem with providers bringing more and more products to market just to see what works?

Fulton: There needs to be innovation with regulation. Regulators have held up approval on new structures, causing sponsors to abandon some ideas. If I want to create portable alpha, like the fund Corey described, it’s a six- to nine-month process. Even a simpler product, like a market-weighted, concentrated basket of 20 biotech stocks, will still take three to four months to get approved. Something that simple should be able to come to market faster. The market is changing all the time, and we can’t adjust quickly enough with this process. So you have to be great at predicting change. I’m fine with regulation, but there has to be an expediting process.

Nadig: You can launch a new fund onto an existing pile of funds quickly. When BlackRock builds a new country ETF for its suite of single-country ETFs, it is effectively an amendment.

But there is no reason to expect the process to get much faster, because there’s still a giant pile of paperwork. That isn’t holding back the ETF industry—300 products launched this year already. About the same amount have shut down. I don’t feel we need to have that pace go up to 1,000 a year. Regulatory reforms are needed to even the playing field among providers and make it clear how the structure is supposed to work. Right now, a product from iShares lives under a different set of rules than one from Elkhorn

What needs to happen on the regulatory front?

Nadig: The ETF is a structure living via loophole—every ETF that comes to market is, in effect, breaking the rules. That’s why providers need to file for exemptive relief with the Securities and Exchange Commission; they’re essentially asking permission to break the rules. That is a fundamentally bad way to run an industry.

The fact ETFs have succeeded despite that is phenomenal. There is no desire in Congress to reform the ’40 Act [the 1940 legislation that governs mutual funds] or to pass an ETF rule. The last time that was floated was in 2008, and it died on arrival. I see zero movement for any broad regulatory reform of core investment products.

On fees: “If you can’t compete, you’re wrecked.” —BEN FULTON
On fees: “If you can’t compete, you’re wrecked.” —BEN FULTON Photo: Matt Furman for Barron's 

There’s a lot of concern around ETFs that own illiquid securities, like high-yield bonds, bank loans, and foreign stocks. Is that a problem?

Hoffstein: Are ETFs that own illiquid securities structurally dangerous for the market? No, I don’t think so. The concern is that because ETFs offer secondary liquidity—the ability of ETFs to trade without touching the underlying holdings—the ETF’s value can meaningfully stray from the net asset value of the underlying holdings. If the underlying portfolio is illiquid, its prices can get stale. Maybe the question should be: Are investors educated enough to know that the value of the ETF can trade above or below its NAV on any given day? But that secondary liquidity is an innovation born from ETFs.

So it’s a feature, not a bug, that an ETF’s liquidity can be greater than its holdings?

Nadig: ETFs have effectively saved some illiquid asset classes. The high-yield bond market dried up, because bond dealing became an illegal activity for most banks. [In 2014, the Volcker rule effectively dismantled the proprietary trading desks at big banks, which had served as the primary market makers for high-yield bonds.] ETFs took the ability to basket a bunch of high-yield bonds and find another place to trade them—in this case, the stock exchanges. That became a saving grace for an asset class that otherwise would have become a person-to-person market owned by issuers, insurance companies, and Pimco. By moving that liquidity on screen into HYG [iShares iBoxx $ High Yield Corporate Bond] or JNK [SPDR Bloomberg Barclays High Yield Bond], we’ve created a price discovery vehicle for junk bonds.

What do you mean by price discovery?

Fulton: Take the PowerShares QQQ [QQQ]. Let’s pretend that Apple [AAPL] stopped trading for whatever reason. The ETF would continue trading. If you knew Apple represented a portion of that portfolio and stopped trading at X price and the ETF is trading at Y—if we can see that the other 99 stocks are priced exactly the same, we can calculate what Apple stock will open at. We can isolate a single stock, because the market’s view of that stock is reflected in the ETF’s value. In a mutual fund, no one knows until the end of the day.

Nadig: Junk bonds are illiquid; there is nothing you can do about that. If the bottom falls out of junk bonds and all of a sudden everyone wants to be out, it will fall. Laws of supply and demand don’t get repealed in an ETF. But the holdings in these very liquid junk-bond ETFs—some of which will go days without trading—are about as illiquid as you can get in a security. How do you price that underlying bond that doesn’t trade? You go to a bond-pricing service and they tell you: We think it is worth X today, because of what this other bond that is like it traded at yesterday or 10 minutes ago. The ETF will expose that problem because the ETF will trade down first.

Hoffstein: When you say bond-pricing service, you mean State Street or BlackRock’s trading desk?

Nadig: I mean Bloomberg’s junk-bond pricing service, or something like it. The input into evaluating the theoretical price of this untraded bond is where the ETF is trading. Usually, you figure out how much the ETF is worth by looking at the price of all the things it holds, but here holdings are retroactively priced based on where the ETF trades.

Ritholtz: How accurate is that compared to actually seeing the bonds trade?

Nadig: It’s not, but there is no better way to do it, because until somebody trades that individual bond, there is no price. The prices are determined by the market; if there is no market for this piece of junk paper and nobody is willing to actually take it off your hands, your only option is a fire-sale price from some big asset manager’s bond desk. The ETF structure doesn’t make junk bonds more liquid, it simply creates a price-discovery mechanism.

Hoffstein: My favorite example of this is the five-week Greek stock market shutdown. The Global X MSCI Greek ETF [GREK] continued to trade during that period. Trading of stocks on the Greek stock exchange was halted, but the Global X ETF continued to trade on a U.S. exchange and was the only vehicle of price discovery. When the market reopened, Greek stocks fell about 20%—the index came down to where the ETF was.

OK. On to the term everyone loves to hate—smart beta.
In 2014 and 2015, these alternative indexes, many of which weight their indexes according to certain stock qualities known as factors, took in $127.5 billion, according to research firm ETFGI. In 2016 and 2017, inflows dropped to $46 billion and $53 billion, respectively. Is this the end of smart beta? 

Nadig: I don’t think smart beta is dead. What we are calling smart beta now we called “tilt and timing” in 1992 and quant before that. Flows have been overwhelmingly going to low-cost beta. We haven’t seen huge flows into smart beta despite the continuing flood of product launches.

Ritholtz: There’s a huge swath of academic literature that says, over time, value will beat growth, small will beat large, quality will beat lower quality, momentum beats lack of momentum, etc. We started with the Fama/French three-factor model [developed by economists Eugene Fama and Ken French], and now there are arguably six, seven, or eight factors. But while these factors will outperform over the long run, many won’t for periods of time. We’re in the middle of a period where growth is trouncing value. We had the same situation in the 1990s, when value was doing terribly and Warren Buffett had supposedly lost his touch.

Nadig: The real issue for investors is their timeline. Most of the research says you need to hold factors for seven years for your portfolio to outperform, which means you have to be willing to lose for three years to gain for four. Most investors don’t stick it out for three years of underperformance.

There’s a near-constant but low-level buzz around actively managed ETFs. Pimco and DoubleLine have had great success with their actively managed bond funds. Davis Advisors launched three actively managed stock ETFs earlier this year, but they are still small. Will actively managed ETFs ever rise? Do they solve a problem?

Hoffstein: This debate is all about where you draw the line in the sand between active and passive. I consider most indexed smart-beta funds to be active. They purposely deviate from market-cap weighting. So based on that definition, I would say active ETFs have already been incredibly successful. Just because they do it in a transparent, systemic, and rules-based manner doesn’t mean it isn’t active.

Smart-beta ETFs solve a problem in that they allow managers to replicate their market views in a more consistent manner and price them competitively. What about non-transparent active ETFs, which Dave mentioned earlier?

Nadig:There are many proposals that would allow active management in an ETF without the transparency ETFs are known for. The most popular one is the model put forth by Precidian [a New Jersey–based ETF shop in which Legg Mason has a minority stake]. It puts a third party between the market and the fund; that third party knows what is in the fund, but the outside market doesn’t.

How does that work?

Nadig: So there’s the fund, the third party we’ll call Bob, and Alice, the investor. Alice wants 50,000 shares of an ETF. The fund tells Bob what it needs, then Bob, after collecting the check from Alice, goes and buys all those things the fund asked for and gives the shares to Alice. Bob is contractually obligated to never tell anyone what the fund is buying.

Sounds complicated, and not great for Alice. Do nontransparent active ETFs solve a problem?

Nadig: It solves a problem for the portfolio manager but not necessarily for Alice, unless she really believes she’s getting a fund with some unbelievable special sauce. That’s the story managers use when they won’t disclose what they’re buying. I personally don’t buy that story.

A portfolio manager taking big, high-conviction positions in microcap stocks may not want to show their hand, so maybe an ETF isn’t the right structure for that guy’s fund. That said, I do think eventually one of these nontransparent active structures will get approved, and you will see a bunch of active managers come to market.

Hoffstein: As an active manager, I don’t see the need to hide my trades. Even if you put all of the funds operating in illiquid securities together, they make up a small piece of the whole.

Let’s talk disruption in the advisory business.

Fulton: It goes back to distribution innovation. What is a robo-advisor but an account-opening scheme?

Hoffstein: Portfolio management has been commoditized; robo-advisors are proof of that. ETFs have brought costs down dramatically, and technology has made making asset-allocation models easier and cheaper. Advice and financial planning are the advisors’ best value-add.

Nadig: The headlines go to Wealthfront and Betterment, but the assets are going to Vanguard. To open a robo account at Vanguard, you have to talk to a human being. That bionic model, where a human is involved in the discussion, is stolen from Canada, where it is a legal requirement. That model is going to dominate precisely because of that behavioral coaching component to a financial relationship, which is where most alpha will come from. You could be in a mediocre portfolio, but get the behavioral call right—i.e., not selling on the day the market crashes and not waiting until it runs up 30% before you get back in—and a mediocre portfolio will beat the pants off the guy who has the perfect asset allocation, but pulls the trigger at exactly the wrong time.

Ritholtz: Vanguard’s robo-advisor is coming up on $100 billion in assets incredibly quickly, though no one will officially say it. They’re several times bigger than any of the top robo-advisors and growing like a house on fire. The challenge for every advisor today is to explain what their value-add is, because the portfolios are, if not free, cheap.

There’s a lot of consolidation in the ETF business: Invesco’s PowerShares picked up Guggenheim’s ETFs; WisdomTree bought a piece of ETF Securities’ suite in Europe. Turner Investments just acquired Elkhorn. Why wouldn’t an active shop just build its own ETF business?

Fulton: Some do build their own, but you want the right person leading the group. Turner, which has been traditionally active, realized ETFs were the future, so they needed passive sooner rather than later. The gentleman who runs it has a big vision for incorporating research and other global partners. He didn’t want to just put a big toe in; he wanted to jump in. We sold our firm because we realized that being small does not make it easy to stay relevant. You have to fight to get to that $10 billion level.

This gets back to your point about distribution.

Fulton:You are right there. We needed to be bigger to be relevant and be a part of distribution strategies. On our own, that’s hard to do. There is a ton of pricing pressure, and now with insurance companies in the mix, it’s only going to get worse, as large companies try to attract assets quickly. If you can’t compete, you’re wrecked.

Thank you, gentlemen.

The World Trade Organisation

As WTO members meet in Argentina, the organisation is in trouble

Not all those problems stem from the Trump administration, but some of the most serious do

“EVERYBODY meets in Buenos Aires,” said Cecilia Malmstrom, the European Union’s trade commissioner, days before heading there for the World Trade Organisation’s (WTO) biennial gathering of ministers, which opens on December 10th. Some non-governmental organisations have been blocked by the protest-averse Argentine authorities, but a meeting of people will indeed take place. One of minds is another matter.

Most participants can agree on one thing. The WTO, which codifies the multilateral rules-based trading system, needs help. President Donald Trump has railed against it and threatened to pull America out. Without American leadership, there is little hope of reaching new deals. And even as the WTO’s dealmaking arm is paralysed, the Trump administration is weakening its judicial one by starving it of judges.

Despite Mr Trump’s threats, America does not seem on the verge of crashing out of a system it helped to construct, to rely entirely on bilateral trade deals and remedies. He may think that true reciprocity means American tariffs to match Chinese ones. (For goods, America’s average 3.5%, China’s 9.9%.) But Congress is likely to stymie attempts to raise duties, and anything he does manage will face swift and painful retaliation. Robert Lighthizer, the United States trade representative, seems to be sticking to the WTO’s rules for now. On December 4th, for example, he requested evidence relating to solar-panel imports to help make the case that any tariffs would be WTO-compliant.

But an institution can be damaged without blowing it up. Over the past few weeks organisers of the meeting in Buenos Aires have been managing expectations down. No one thinks much will be agreed on. Some sigh that a committed American administration might have achieved an agreement on curbing fishing subsidies, revived one easing barriers to trade in environmental goods, and organised an ambitious agenda for e-commerce. Instead, the Americans have been bickering over the language in a proposed joint statement. They quibble with references to the “centrality of the multilateral trading system” and to “development” as an objective.

Still, it is unfair to blame the Trump administration alone for the likely lack of progress in Buenos Aires. The dealmaking arm of the WTO has not worked for years. India routinely holds agreements hostage to its demands. The Chinese scuppered an agreement over environmental goods. Some developing countries complain that deals to help them should be agreed on before new areas are opened up. Updating the rules needs consensus among all 164 member countries, which is almost unattainable. “Even the US at its most constructive isn’t going to fix the system where it is now,” says Andrew Crosby of the International Centre for Trade and Sustainable Development, a Geneva-based think-tank.

The sabotaging of the WTO’s appellate body, however, is clearly the handiwork of the Trump administration. On December 11th the term of Peter Van den Bossche, the European judge on the body, will expire. He will be the third judge whose reappointment the Americans have blocked.

On the present course, by the end of 2019 too few judges will be left to rule on new cases (three are required). Mark Wu, a law professor at Harvard University, worries that gumming up the judicial arm may make countries doubt that the WTO is the best forum for settling disputes. “The risk is less of an immediate explosion,” he says, “than a slower death by a thousand cuts.”

Mr Lighthizer has hinted at a return to the old, pre-WTO system of resolving trade disputes—by national muscle rather than lawyers. Ms Malmstrom says she cannot envisage going back to that. But the impasse has no obvious way out. Any manoeuvre to bypass the American blockage of the appellate body would be politically, if not legally, untenable. And the Americans have not said what reforms they want.

Bull in a China shop

As the Trump administration kicks at the working leg of a limping institution, it is worth recalling that previous American administrations have also felt frustrated with the WTO. Few would disagree that it needs reform. In particular, China, described by Ms Malmstrom as the WTO’s “problematic client”, has an economic model that sits awkwardly inside the WTO system. The organisation’s rules were drafted in the early 1990s with transitional economies like those of Eastern Europe in mind. Hosuk Lee-Makiyama of the European Centre for International Political Economy, a Brussels think-tank, says they are toothless against China’s “state-capitalist model”, which is far more influential than was envisaged. A case working its way through the dispute-settlement system concerning China’s treatment by its biggest trading partners (see article) highlights an old tension between the WTO’s most important members.

If the frustrations are familiar, the strategy is not. To brandish a stick at China, the previous American administration sued it at the WTO for subsidising export industries. Dangling a carrot, it negotiated a big regional trade deal with “21st-century rules”. This administration is all stick and no carrot. Asked whether she thinks the Trump team wants to destroy the system, Ms Malmstrom says: “I don’t know.” Mr Trump may think that the system is so broken that it must be smashed before it can be fixed. His approach risks making that view self-fulfilling.

Manchester City and the ‘Disneyfication’ of football

The team’s Arab owners are developing a business model based on a global network of clubs that could upend the sport

Murad Ahmed in Manchester

Even diehard football fans would struggle to identify Yangel Herrera. Yet if Manchester City’s billionaire owners are correct, the Venezuelan midfielder could be the first proof that its global business model is paying off.

The 19-year-old plays for sister club New York City, a US team founded four years ago as part of the City Football Group, an umbrella organisation stretching from Australia to Japan, Spain, Uruguay, the UK and US. It is a franchise model dubbed by some as the “Disneyfication” of football and which its Arab owners believe is the future of the world’s most popular sport.

Mr Herrera’s place in that plan is yet to come to fruition. While he will not play in Sunday’s Manchester derby, pitting City against their neighbours United in a match expected to attract a worldwide television audience of hundreds of millions, he is one of an estimated 1,000 players CFG clubs can draw on — a reservoir of talent that stretches from academies to the first team.

Signed in June from Atlético Venezuela in Caracas for an undisclosed fee, Mr Herrera was identified using the group’s industrial-scale database of 300,000 players. Manchester City immediately loaned him to New York City where coach Patrick Vieira was searching for a dynamic player to add to his Major League Soccer side. If all goes to plan, Mr Herrera may next play in Manchester. He would then become the stand out figure in a grand footballing project aiming to upend the football industry.

Yangel Herrera, 19, signed from Atlético Venezuela, is currently playing at New York City FC, on loan from Manchester City © Getty Images

“Players need time to develop” says Mr Vieira, the former Arsenal and France player. “If Yangel Herrera manages to play for Manchester City . . . that would be exciting for us.”

CFG says its ambition is to build the “first truly global football organisation” and its owners are at the vanguard of a growing trend for wealthy individuals to control multiple clubs. The intention is for each of the teams in the network to be profitable in their own right, but co-operate to identify and train the world’s best players, while securing marketing deals to fund the wages of footballing superstars.

At its heart is Manchester City, bought in 2008 by Sheikh Mansour bin Zayed al-Nahyan, the billionaire businessman, deputy prime minister of the United Arab Emirates and member of the Gulf state’s royal family. He promised to transform the team — which had spent decades in the shadow of its more successful city rival Manchester United — into a global megaclub capable of winning Europe’s biggest prizes.

At the time such ambition was ridiculed by United’s then manager Sir Alex Ferguson, who described it as the excitable talk of “noisy neighbours”. Back then, it was United that provided the blueprint for success, both on and off the pitch, winning 13 Premier League titles and two Uefa Champions Leagues in the Ferguson era — a period in which it pursued international sponsorship and marketing deals. It remains the world’s wealthiest club in terms of revenues, €689m in 2015-16, according to Deloitte. By comparison, Manchester City revenues over the same period were €525m.

In reality Sheikh Mansour’s estimated personal wealth of $20bn, from holdings in Abu Dhabi’s oil and gas entities, give the club greater financial resources than all its rivals. His largesse helped City overtake United on the field, spending £200m a year on transfers and wages, incurring several seasons of heavy losses but winning two Premier League titles in 2012 and 2014. It also attracted investors, with the China Media Capital consortium paying $400m for a 13 per cent stake in CFG in 2015, valuing the group at more than $3bn.

In recent years, the Emirati prince has funded a different spending spree. In 2013, Manchester City joined with the New York Yankees to pay $100m for the franchise rights to create a football team in New York. CFG then struck smaller multimillion-dollar deals to buy Australia’s Melbourne Heart, since renamed Melbourne City, and Uruguay’s Club Atlético Torque. It also acquired minority stakes in Yokohama Marinos in Japan and Spain’s Girona.

Other groups and individuals are now seeking to emulate the model of multi-club ownership. Red Bull owns football clubs in the US, Austria, Germany and Brazil, partly as a way to promote its energy drinks. But few can match CFG’s ambition, which has already seen it expand across four continents. The group is also evaluating takeovers in China, India and Southeast Asia.

Pep Guardiola, who won trophies previously with Barcelona and Bayern Munich, was a long-term Manchester City target © PA

CFG executives say the goal on the pitch is for all the clubs to play attacking, possession-based football, in the style laid down by City’s head coach Pep Guardiola, who was previously at the Spanish club Barcelona. They also want to outdo United’s balance sheet, by exploiting “economies of scale” by convincing sponsors to pay for marketing deals that apply across its teams.

Critics argue the elaborate business model is a smokescreen to satisfy Europe’s so-called Financial Fair Play rules, introduced in 2011, designed to prevent individual clubs from spending beyond their means to buy success.

A senior Premier League club executive describes CFG as a “hall of mirrors” designed to funnel revenues back to the central entity in Manchester and justify its enormous spending on players. A £400m 10-year deal with Etihad, Abu Dhabi’s state airline, to become Manchester City’s stadium and shirt sponsor, led to accusations of “financial doping” by Andrea Agnelli, president of Italy’s Juventus. The group admits that Manchester City, which benefits from the Premier League’s multibillion-pound TV contract, is the only profitable club in its network.

Others suggest CFG represents a geopolitical play, designed to exert Emirati soft power by creating winning teams in the world’s favourite sport. One Premier League club owner refers to Manchester City as “the nation state” playing an entirely different game to its rivals.

“Abu Dhabi is not doing this because it likes Levenshulme [a district of Manchester],” says Simon Chadwick, professor of sports enterprise at Salford Business School. “They are doing this to seek sustainable revenue streams from the investments that will provide currency inflows in 10, 20, 50 years’ time when the oil and gas is gone.”

The origins of the CFG network lie not in Manchester or Abu Dhabi, but Barcelona. In 2003 Ferran Soriano, a management consultant, was elected to the board of the Spanish football club and set about transforming the institution. In his book Goal: The Ball Doesn’t Go In By Chance, Mr Soriano says he was influenced by the work of sports academic Stefan Szymanski, which showed that the best predictor of a club’s success was the wage bill of its playing squad.

“If you want a champion team, a team with a chance of regularly winning championships, then you need to work consistently to have a big club that generates enough revenues to be able to sign the best football talent available,” wrote Mr Soriano. “It has absolutely nothing whatsoever to do with luck.”

Fearing being outspent by richer clubs such as Real Madrid and Manchester United, Barcelona pushed to reach financial parity. Between 2003 and 2008, it almost trebled revenues from €123m to €309m and cut the gap to its rivals. On the pitch, too, it has been successful, winning four Champions League titles since 2006.

Mr Soriano was following a commercial model first adopted by Manchester United: increase match-day ticket prices, seek sponsorship deals outside its home market and go on the road for pre-season exhibition tours of North America and Asia. But he wanted to go further, pointing to the franchise model of Walt Disney — which translates movies into different languages, creates merchandising around characters and film-related theme park rides — and suggested a similar formula could be applied to sport.

Mr Chadwick describes the idea as the Disneyfication of football. “You can’t take the first 11 to America one week, China next week, South Africa the next,” he says. “So what you do is franchise the name, sponsors, kit and image.”

Barcelona’s leadership rejected the Soriano idea to launch international sister clubs, and he left the club in 2008. Four years later he joined Manchester City as chief executive. “The week after Ferran joined he was already in New York speaking to Don Garber [commissioner of Major League Soccer],” says Omar Berrada, a former Barcelona executive who now works alongside Mr Soriano as Manchester City’s chief operating officer.

CFG believes the network allows City to spread its brand by attracting local supporters to each of its clubs while also adding to the value of commercial deals, in ways unavailable to even the biggest European clubs. Tom Glick, Manchester City’s chief commercial officer, points to the example of carmaker Nissan, the majority owner of the Yokohama Marinos. In 2014, CFG took a 20 per cent stake in the Japanese club. Nissan subsequently struck a deal worth more than £20m as a sponsor of all the CFG clubs.

They also argue that the group structure helps to spot players and place them within the network. Investments in clubs such as Girona, and a partnership with NAC Breda in the Netherlands, are designed to create finishing schools for young starlets.

“We have 10 players within our system that are getting experience in the Eredivisie [the Dutch top division] or La Liga [Spain’s top league],” says Brian Marwood, the ex-Arsenal player who heads CFG’s global scouting operation of 50 talent spotters on five continents. “That is invaluable.”

Yet when table-topping Manchester City — which is seeking a 14th straight win in the Premiership — face United on Sunday, its team will be made up of expensive imports rather than young players developed within the CFG network.

Executives plead for patience, saying the system has already created a new revenue stream. One example is Aaron Mooy, an Australian who played for Melbourne City and has since moved to Huddersfield Town in the Premier League. According to people close to the club, Mr Mooy’s transfer fee of about £10m was more than the price CFG paid to acquire the Australian club.

Aaron Mooy, an Australian international who played for Melbourne City, was sold to new Premier League side Huddersfield Town for £10m © AFP

Still, Professor Szymanski, whose work influenced Mr Soriano, doubts the business model. Neither notoriously parochial fans, nor commercial sponsors, will care if a club is part of a larger brand, he says. He adds that there is only “marginal benefit” in running a whole club compared with opening cheaper youth academies in multiple locations. Worse, he fears CFG risks “managerial overstretch” by trying to run several clubs, rather than focusing attention on one.Prof Szymanski advises other club owners to bet on Manchester United’s business model, rather than the “riskier” one of CFG. But he adds a caveat: “When you have a bank like Sheikh Mansour to draw on, why wouldn’t you? If you are in Soriano’s position, what’s to lose? You’re betting with someone else’s money . . . he might hit the jackpot.”

How CFG is extending its reach

The CFG web of clubs is set to grow. The 2015 purchase of a 13 per cent stake in the group by China Media Capital was seen as a prelude to acquiring a club in the country.

Omar Berrada, Manchester City’s chief operating officer, says CFG has been quoted “crazy valuations” for clubs in the China Super League, the country’s top division, and asked to pay hundreds of millions of dollars to acquire clubs that were unprofitable and under heavy debt. “Clearly, we’re not going to make a crazy investment,” he says.

Without ruling out buying a club in China, CFG says other efforts, such as creating football schools to train young players, a key goal of the Chinese government, makes “more economic sense”.

India is another option, but CFG is yet to find a commercial partner, as with the Yankees in New York and Nissan in Yokohama, to navigate the Indian market. Mr Berrada lists Thailand, Vietnam, Indonesia and Malaysia as other potential territories for growth.

The model could yet be tested by the sport’s authorities. In August, CFG acquired a major stake in the Spanish club Girona, alongside an investment vehicle controlled by Pere Guardiola, football agent and brother to Manchester City’s head coach. “It’s definitely not to keep Pep here,” says Mr Berrada of the Girona deal. “It’s not any sort of a hook to keep him interested in the group.”

Still, the move contains regulatory risks. Fifa, world football’s governing body, has rules against a single owner controlling clubs in the same competition. CFG’s initial strategy avoided this by expanding into countries where teams had little chance of facing each other on a regular basis. But if Girona, currently 12th in La Liga, were to become more successful, it could meet Manchester City in European competitions.

Patrick Vieira, a former Arsenal player, now coaches New York City FC © AFP

CFG has gained encouragement from a ruling from the Court of Arbitration for Sport this year, which found that RB Leipzig and Red Bull Salzburg could both compete in the Champions League this season, as their parent group did not exert “decisive influence” on the teams holding its name.

Patrick Vieira, the New York City coach, insists CFG “plays by the rules and regulations”. He says: “Think about Real Madrid and Barcelona, in England all the clubs have a lot of money. This is a different way of working, by people who are more creative than other people. It is one of the smartest moves taken in football in the past 20 years.”Statistics for the graphic on passing sequences and directness were provided by analysts Mark Thompson and Euan Dewar, whose calculations were made using data from Opta.

Muddled model

Local-government finances in China are a dangerous mess

The best fix is a political one

AS CHINESE officials admit, one of the biggest threats to the country’s financial stability is a reckless build-up of local-government debt. What they are less keen to admit is that local governments’ thuggish behaviour, such as grabbing land to sell to developers, and failing to provide the services expected of them, has become a cause of unrest.

One reason local governments in China are dysfunctional is the way their finances work. They have very limited tax-raising powers of their own. Issuing bonds requires tricky high-level approval. Much of what they raise has to be handed over to the centre, which then redistributes money back to the provinces—supposedly according to their needs. To see how well that works, compare the shabby state-run schools and hospitals of rural counties with their smart counterparts in wealthy cities. No wonder local officials often turn to dodgy ways of generating cash, such as using shadowy “financing vehicles” to borrow money from Banks.

At the root of all this is disharmony between central and local governments. You might think that, in China of all places, the centre reigned supreme. At a Communist Party congress last month, its leader, Xi Jinping, acquired even greater power by filling jobs with his allies. Yet local governments will not always heed him, even with his new clout. True, they will put on a show if it does not cost much—as when officials from the sycophantic government of Henan province went to pay homage to a Paulownia tree planted by Mr Xi, who had urged delegates at the congress to “follow the leadership core”, ie, him. But do not expect Henan to leap into action to honour Mr Xi’s pledge at the congress to “improve community-level health-care services”. Where is the money for that?

In the coming years, local governments will get only sulkier. The central authorities are suppressing the murky financing vehicles they have used to circumvent restrictions on borrowing. Less land is readily available for local authorities to seize and sell to developers. As the economy slows, the tax take will grow more slowly, too.

Taxation, with representation

The central government is looking for remedies. It is working on a crucial one: to clarify which level of government is responsible for what spending, so as to avoid the common problem of buck-passing. But it is dithering over another good fix, the introduction of a property tax. Local governments around the world rely on such a levy, based on the market value of homes.

China’s government is fearful of upsetting middle-class homeowners. Local officials worry that a property tax would expose their possession of ill-gotten luxury villas, since it would involve setting up a database of who owns what.

To make sure local governments manage their budgets wisely, more controls will be needed. Mr Xi hinted at what this would mean with his admission at the congress that demands for democracy were “increasing by the day”. He did not mean the multiparty kind, although some people do want that. Instead Mr Xi was acknowledging that the citizens want a greater say. He is right.

Since 2014 governments at every level have been required to publish their budgets. How about going a step further? Local legislatures, like the national one, are rubber stamps. Mr Xi should resume an experiment that his predecessors briefly toyed with, and allow independent candidates to stand for election to them. That would give citizens a long-stifled voice. It might even help ensure that their money is spent well.

Why a Nobel Laureate Believes Social Businesses Can Cure Poverty


Nobel winner Muhammad Yunus explains how so-called social businesses can make everyone an entrepreneur and remedy inequality.

413CSgyqMQL._AC_US327_FMwebp_QL65_ A world without poverty, unemployment or environmental devastation seems like a utopian dream. But it doesn’t have to be. In his new book, Nobel Peace Prize winner Muhammad Yunus shares his vision for a kinder, gentler planet. It starts with recognizing what he describes as the inherent cruelty of capitalism, the need to value the abilities of every human being and understanding that saving the environment must be a collective effort.

Yunus, who won the Nobel for his work in microfinance, encourages us to see the world not through the lens of profit, but of social impact. He spoke about his book, A World of Three Zeroes: The New Economics of Zero Poverty, Zero Unemployment and Zero Net Carbon Emissions on the Knowledge@Wharton show, which airs on Wharton Business Radio on SiriusXM channel 111.

An edited transcript of the conversation follows.

Knowledge@Wharton: Your life’s work has been looking at ways to lift people out of poverty.

Do you believe there is a path to eliminating poverty as much as possible around the globe?

Muhammad Yunus: Yes, indeed. Poverty doesn’t come from the poor people themselves; poverty is imposed from outside. It’s something that we have in the economic system, which creates poverty. If you move those problems, the system, there’s no reason why anybody should be poor.

I give the example of a bonsai tree. If you take the best seed from the tallest tree in the forest and put it in a flowerpot to grow, it grows only 2 feet or 3 feet high, and it looks cute. It’s a replica of the tall tree. You wonder what’s wrong with it. Why doesn’t it grow as tall as the other one? The reason it doesn’t grow is because we didn’t give it the base on which to grow [bigger]. We gave it only a flowerpot. Poor people are bonsai people. There’s nothing wrong with the seeds. Simply, society never gave them the base on which to grow as tall as everybody else.

One struggle that I had all of my life is the banking system doesn’t reach out to them. I kept saying that financing is a kind of economic oxygen for people. If you don’t give this oxygen to people, people get sick, people get weak, people get non-functional. The moment you connect them with the economic oxygen, the financial facility, then suddenly they wake up, suddenly they start working, suddenly they become enterprising. That is the whole thing missing. Almost half of the population of the entire world is not connected with the financing system.

Knowledge@Wharton: How do you start to build out that system?

Yunus: We created a bank for the poor people called Grameen Bank, or Village Bank. We work with the poor people in Bangladesh. It became known globally as microcredit. Today, Grameen Bank has over 9 million borrowers in Bangladesh, and 97% of them are women.

That idea has spread all around the world, including to the United States. There is an organization called Grameen America, which lends money to extremely poor people in the cities of the United States. There are seven branches of Grameen America in New York City, and they total 20 branches all over the United States, including Boston, Houston, Omaha, and so many others.

Nearly 100,000 borrowers are given loans of about $1 billion right now, and they pay back nearly 100%. But we had to create this separate [microcredit] piece. That’s the point I’m making — banks don’t want to come out. We need to address that and the whole problem of wealth concentration, which I focus on in the book.

All of the wealth of the world, all of the wealth of the nations, is concentrated in fewer and fewer hands. Today, eight people in the world own more wealth than the bottom 50% of the people.

Tomorrow, it will be less than eight, and the day after that it will still be less, and soon we will have one person owning 99% of the wealth of the entire world because it’s getting faster and faster.

The whole machine, which you call the capitalist system, is sucking up the wealth from the bottom and passing it to the top. That’s a very dangerous system. We have to be aware. I said this is a ticking time bomb, and we have to reverse the process, change the process.

Knowledge@Wharton: Many Americans don’t consider the concentration of wealth and distribution of poverty to be a global problem. You are saying that it is.

Yunus: It is a global problem. It happens in every city, every county, every state, every nation.

The system is built that way.

Knowledge@Wharton: Where carbon emissions are concerned, are you disappointed in some of the environmental decisions made by President Trump, especially with pulling out of the Paris Accord?

Yunus: It’s not only disappointing, it’s very shameful that the United States can take an action like that. It took years for the whole world to mobilize the feeling that we have to protect this planet because we are on a most dangerous path. We soon will come to the point of no return.

Even if we try, we cannot undo the things that we have done. But we still have a chance. We came all the way from everywhere to Paris to get all of the world’s leaders, all of the nations to sign. And suddenly the United States government withdraws from that. That’s the most shocking thing that could happen.

Luckily, mayors and the governors are saying, “No, we are still on the path. We will continue to do that.” I hope the United States will reconsider that and continue to become the leader of the whole movement of stopping global warming.

Knowledge@Wharton: Is it surprising that China has taken the leadership role in this?

Yunus: Yeah, it’s amazing. The assumption was that China and India would say (to the West), “Well, you got your economic development done, so you now are talking about global warming.

We have to go through it because we have no alternative. After we reach your level, then we’ll consider that.”

The reality is completely different. Today, China and India are leading the way. They said, “We are on our own making decisions, not because of the pressure of the world. We do it because we feel that we have to protect the planet with our own action.”

Knowledge@Wharton: Let’s talk about your views on zero unemployment. In the United States, most people believe that we are at full employment right now, yet we still have 4% to 5% unemployment. There are still a lot of people that are marginally attached to the workforce. It seems that is a term that you are not fond of at all.

Yunus: That’s right. We are human beings, and we are not born on this planet to work for somebody else. They are an independent person. They are an enterprising person. That’s our history. That’s in our DNA.

When we were in the caves, we were not sending job applications to each other. We were not sending job applications from cave No. 5 to cave No. 10. We went ahead and got things done.

That’s what we were known for. We are go-getters. We are problem solvers. But somehow capitalist systems came and they said, “No you have to work for somebody else. That’s the only way you can make a living.”

I say that’s absolutely the wrong idea. We have to go back to our entrepreneurship [roots]. We are all entrepreneurs. The whole problem of unemployment came because of the concept of employment. If we didn’t have the concept of employment, you don’t have the problem of unemployment because everybody can be an entrepreneur. That’s what we do in Bangladesh.

We address all the young people from Grameen families. We say, come up with a business idea and we’ll invest in your business. We are a social business investment fund so that you can come with any business idea. We invest in you, and you be successful and return the money that we give you. We don’t want to make money from you. All of the profit belongs to you so that you move on. Thousands and thousands of young people keep coming every month, and we keep on investing in them every month.

Every family, every school will be teaching the young people that they have two options as they grow up. You can be a job seeker or an entrepreneur, so prepare yourself which way you want to go.

Today, there is no option. Everybody is told they have to get the best grades and get the best job in the world, as if jobs were the destiny of a human being. That’s belittling human beings. Human beings are not born to end up spending their whole lifetime working for somebody else.

Knowledge@Wharton: Do you see the number of social-impact businesses increasing around the world?

Yunus: I see it every day, every moment, because people really have that feeling inside of them.

This my thesis of what I promoted in the book. The capitalist system is based on an interpretation that human beings are driven by self-interest, meaning selfishness. That is absolutely the wrong interpretation of a human being. A real human being is not all about selfishness. A real human being is selfishness and selflessness at the same time.

You double up both sides, whatever strength you want to put in each side. That’s up to your upbringing, your schooling and so on. But you have two options, and you can do both. You can create business to make money for yourself — that’s a selfishness — and you can create business to solve problems, make other people happy in the world, protect the world. That’s a selflessness, and that’s a business that we create called social business.

Social business is a non-dividend company [meant] to solve human problems. We completely eliminate the idea of making personal profit in social business. We totally dedicate ourselves to solving problems. Now that the idea of social business is growing, young people are coming with business ideas, big businesses are coming up to create social businesses alongside. I’m very happy about that. Hopefully, schools like Wharton will be teaching social business as a separate subject and also give social MBAs to young people who will be preparing to operate social businesses, manage social business, create social business.

Knowledge@Wharton: Why didn’t we see social businesses 50 years ago?

Yunus: We don’t have to blame ourselves for not seeing it 50 years back, but we must blame ourselves why we are not seeing it now. Why are we delaying? Look at the health care problem.

Health care could be done by the businesses to make money, make profit. It’s become more expensive, more complicated, more political because they want to make money.

Health care could become a charity where government gives health care free for everybody.

Many countries do that. Or health care can be social businesses — businesses that solve problems, not making money for any owners, so that they can sustain themselves. There is no tax bar on anybody.

They want to make sure it becomes cheaper and cheaper every day, instead of becoming more and more expensive every day. We can try it out in one state, in one county, whatever you want to do. This is possible once you take out your glasses with dollar signs in your eyes.

You see everything [and it’s] about dollars, how to make dollars. Why don’t you for a while take the dollar-sign glasses off of your eyes and put on the social business eyes? Suddenly, you see lots of opportunity for people to come up with creative ideas, to solve the problems of the people. If we bring all of our creative energy of the whole world, all of these problems that we see every day will disappear.

Knowledge@Wharton: It almost feels like we’re at a tipping point where we’re going to see more companies decide which direction they want to go in.

Yunus: Yes, that’s right. There is pressure on businesses to pay attention to the social causes.

They are gradually getting a little bit conscious about it. That’s a good sign. But I’m saying that whether they are a mega-business, global business, local business, small business, middle[sized] business — each one of them can create a small business of social business alongside their conventional business.

This is not just limited to, one guy will do it and will watch over it. Each one of us can do that and invite all of the creative activity. Once the big businesses and middle businesses get interested, suddenly so many ideas will keep coming. Today, we’ve blocked it out completely from our mind, as if all we have to do in our lives is to make money. That’s the wrong direction completely.

Knowledge@Wharton: A lot of that will rely on the entrepreneurship and the mindset that people have. They have to take the incremental steps and build on it.

Yunus: Absolutely, that’s the whole idea. As I mentioned, the families will be discussing with the young people, and the schools will be teaching them the two options of being an entrepreneur or a job seeker. And when you become an entrepreneur you, have two options.

You can run a business to make money for yourself, or you can run a business to solve people’s problems. And you can do both. You can have a money-making business for yourself, and you can have a social business for yourself, and you feel good that you are doing something that touches the lives of so many people around you.