A Champion Investment Bank Is the Wrong Solution for Europe

Even if Deutsche Bank and Commerzbank merge, they will still struggle with Europe’s flawed capital markets

By Paul J. Davies

The headquarters of Deutsche Bank and Commerzbank are seen in Frankfurt. Photo: Thomas Lohnes/Getty Images 

Newsflash for financial deal makers: Europe doesn’t need an investment banking champion.

If Deutsche Bank DB -1.57%▲ and Commerzbank CRZBY -1.08%▲ agree to a merger, their executives should remember this and it should govern where they make cuts and invest for the future. Investment banking and trading should be curbed dramatically, especially in the U.S. The priority should be corporate and transaction banking.

To be fair, all Europeans should be thinking this way, not just the two struggling Germans. This isn’t defeatism in the face of powerful U.S. competitors; it is about the lack of proper capital markets in Europe.

European capital markets just aren’t that big, and despite years of European Union-level negotiations and proposals, they aren’t developing either. In fact, European equities-trading revenue in 2018 was down by nearly 20% from 2011, according to data from Coalition, a research firm owned by S&P Global. In the U.S., it has grown nearly 50% over the same period.

In bond and currency trading, which has struggled almost everywhere, the European picture is even worse than other markets. In capital raising and deal making, revenue has held up better, but is still less than half U.S. levels.

Advisory and capital-raising work matters because it is what creates the securities for investors to trade. The big reason Europe is so far behind in this area is well known: It still relies much more heavily on bank financing than capital markets. Three-quarters of corporate debt in the U.S. comes from bond markets and the rest from banks, while in Europe only around one-fifth comes from bond markets.

European capital markets have struggled to develop partly because of national rivalries within the EU that help local banks dominate their domestic markets. National champions tend to lead league tables in each country, followed by big U.S. banks, with other Europeans bringing up the rear.

But there is also a problem with savings and investment habits: Europe has more pay-as-you-go pensions, by which current employees or taxpayers bear the cost of retirees, which means there are fewer pension funds to be invested.

Also, European households keep a greater share of savings in bank deposits rather than investing them in financial assets. Europeans keep about 30% of their funds in banks or cash savings, according to New Financial, a think tank, while Americans hold less than 14% this way.

This is a serious issue. It isn’t only bad for the bonus prospects of investment bankers, but it is bad for Europe’s ability to recover from financial or economic shocks. In capital markets, assets get revalued quickly, investors lose money and they move on. In banks, executives don’t want to take the losses so bad loans hang around, capital remains tied up in poorly performing assets and new loans and investments aren’t made.

Senior European officials know this, which is why they continue to push for reform to create the right sort of regulatory playing field. But as long as national politicians want to protect their local banks and Europeans prefer to keep savings in cash, none of those high-level reform efforts will do the trick.

Only in this old-fashioned world of national champions does a commercial-banking focused merger between Deutsche Bank and Commerzbank make sense. If Europe changes, a European investment-banking champion should emerge—but there is no point creating a vehicle for a road that hasn’t been built.


Fund Investors Believe That Cheap is Better. But That’s Not Always the Case

By Crystal Kim 

Fund Investors Believe That Cheap is Better. But That’s Not Always the Case
Photograph by Ken Cedeno/Bloomberg News          

It took some three decades and a financial crisis, but the evangelicals of index investing finally got their message across—low fees lead to better performance.

The past decade has seen unprecedented amounts of money going into index funds. And not just any index funds, but the very cheapest: More than 97% of flows into the $4 trillion exchange-traded fund industry last year went to ETFs that charge 0.2% or less, Bloomberg data shows.

Except some new research indicates that cheaper isn’t always better. That new message is coming from an unusual corner—noted Vanguard expert Dan Wiener, editor of the Independent Adviser for Vanguard Investors and chairman of financial advisory firm Adviser Investments.

“Vanguard’s late founder, Jack Bogle, had it wrong when he said that investors always ‘get what they don’t pay for.’ Sometimes they don’t,” he tells Barron’s. Of course, Bogle wasn’t referencing ETFs, but the performance of Vanguard’s mutual fund share classes versus their ETFs is illuminating, Wiener contends.

Vanguard’s funds require a bit of an explanation. The $5.3 trillion money manager has a unique exception, enabling it to launch an ETF as a share class of an existing mutual fund, so both have the exact same holdings and strategy. Other firms must introduce a whole new fund with an ever-so-slight difference in holdings. This makes performance comparisons difficult—whether you’re weighing an ETF against a similar, but not quite exact, mutual fund, or against another ETF with a similar, but not quite identical, index as its basis. The exception is the handful of BlackRock(ticker: BLK), Vanguard, State Street Global Advisors ,and soon JPMorgan Chase(JPM) ETFs that track big indexes, such as the S&P 500 or the Barclays Aggregate Bond Index.

“It is exceedingly rare to be able to compare ETFs, apples-to-apples. You can’t hold all else equal, which underscores the fee obsession,” says Ben Johnson, director of global ETF research at Morningstar.

Because of the quirk, however, the performance of the portfolios in Vanguard’s ETFs and mutual funds can be compared directly. The firm’s Institutional Plus share class, which has a buy-in of $100 million, has the lowest fee. Admiral shares used to be the next cheapest, but Vanguard’s latest annual report shows that the ETF prices below Admiral shares—though we’re talking about a difference of maybe 0.01%. The firm also lets Admiral share class investors exchange their holdings for an equivalent ETF.

One might think that the share classes advertised as having lower fees would produce better results if both had the same holdings. But that’s not always the case.

Consider the Vanguard Total Stock Market Index fund. In the 10 years through 2018, the Admiral shares (VTSAX) returned 13.25% annually; the ETF (VTI), 13.26%. The ultracheap Institutional shares (VSMPX) did even better, rising 13.31%. That’s to be expected. However, the ETF also returned more than the previously pricier Admiral shares net asset value over certain periods in those 10 years. All the differences were only a matter of basis points—each equal to 0.01%, or just a dollar for every $10,000 invested—but they still might puzzle some investors.

Wiener, who shared with Barron’s how a real portfolio of Vanguard funds performed in his Roth IRA, noted that his return on the ETF shares differed from Vanguard’s stated return on market price—that at which you can buy or sell ETFs, which, in turn, differs from the NAV. Vanguard calculates the market price by taking the midpoint of the bid-ask spread for the trading cost of the ETF.

Why? Well, trading ETF shares involves more variables than buying and selling mutual fund shares. As a result, no ETF trade is done exactly at NAV and depending on when and how it’s executed, an investor could pay more or less than the next person.

A buy-and-hold investor like Wiener, who purchased the ETF at launch in 2008, never doing anything subsequently except reinvesting dividends, might find his real return differing by a few basis points from that reported on Vanguard’s website, because of the trading cost variable. In contrast, open-end mutual funds always change hands at NAV. Thus, gripes: “When you go to sell, how do you know you’ll get as much for your shares as someone who sells at NAV in an open-end mutual fund?”

Rich Powers, the head of ETF product management at Vanguard, says that the price differences “could be a function of penny rounding, which might present as such that one product has outperformed. “It’s a theoretical possibility.”

While the difference in performance is only a few basis points, Wiener says: “Isn’t the whole conversation around fees about basis points?” Indeed, as most investors know, a few basis points more can add nicely to the value of an investment held for many years.

BlackRock’s Fink says markets are poised for a ‘melt-up’

A dovish Fed and robust global economy will lure big investors back to equities

Robin Wigglesworth and Richard Henderson in New York and Owen Walker in London

BlackRock’s shares have lagged behind those of its rivals this year © Bloomberg

Global equity markets are poised for a “melt-up” as signs of healthier economic growth in the US and China reassure big investors that have largely stayed on the sidelines of the 2019 market recovery, according to BlackRock’s Larry Fink.

The chief executive of the world’s largest asset manager said he is optimistic that a “Goldilocks” scenario of improving economic data and more dovish central banks will compel institutional investors that have kept ditching stocks this year to reverse course.

Investment strategists have dubbed the 2019 stock market rally the “flowless recovery”, with equity funds continuing to suffer outflows even as the FTSE All-World index has climbed over 14 per cent — its best start to a year since 1998.

“There’s too much global pessimism,” Mr Fink said in an interview. “People are still very underinvested. There’s still a lot of money on the sidelines, and I think you’ll see investors put money back into equities.”

Bond funds have attracted $112bn of inflows already this year, but equity funds have suffered almost $90bn of investor withdrawals, according to EPFR, a data provider.

BlackRock cemented its position as the world’s biggest fund manager, growing its assets under management to $6.5tn in the first quarter, thanks to strong market returns and inflows of $65bn.

The impact of last year’s market tumult was apparent in the quarter, however. Year-on-year, base fees decreased 5 per cent, because it started the year with less than $6bn in assets. There was a 7 per cent decline in revenues to $3.3bn, which resulted in a 1 per cent fall in diluted earnings per share to $6.61.

However, this comfortably beat analyst expectations of $6.13, and the group saw technology revenue for the 12 months to March 31 increase 11 per cent, driven by its widely used Aladdin investment platform.

Listed investment groups saw their shares tumble almost 26 per cent on average last year — their worst performance since the financial crisis — as investors feared buoyant markets would no longer mask mounting fee pressures across the industry.

BlackRock has this year trimmed jobs and reshuffled its senior management ranks. Mr Fink took a 14 per cent pay cut.

“With fees coming down a lot of the big players are looking for new ways to generate revenues,” said Kyle Sanders, an analyst with Edward Jones. “For BlackRock it’s through software and Aladdin, which isn’t tired to moves in the market.”

The asset manager’s stock rose over 2 per cent on Tuesday to trade at its highest level since early October.

BlackRock is in a years-long battle with Vanguard to dominate the global fund management industry, with the latter catching up fast. However, BlackRock has claimed the top spot for exchange-traded fund global flows this year, which it said was driven by its fixed income products.

The iShares ETF business it acquired from Barclays almost a decade ago now manages almost $2tn, which alone would make it one of the world’s five biggest investment groups.

The average expense ratio of US equity funds have almost halved since 2000 to 0.55 per cent last year, and industry executives expect the trend to worsen. Morgan Stanley and Oliver Wyman’s latest annual study of the asset management industry predicted that revenues from traditional, actively-managed funds in developed markets will shrink 36 per cent by 2023.

BlackRock remains comfortably profitable, but to counteract these pressures it is doubling down on China. Mr Fink has told the FT that the company was in discussions with Chinese regulators over taking control of a local fund manager and ramping up its “alternatives” business.

The Morgan Stanley-Oliver Wyman report estimates that alternative asset classes such as private equity, direct lending and real estate will keep growing at a healthy clip and account for 40 per cent of all investment industry revenues by 2023.

The ravenous appetite for alternative investments has stirred concerns among some analysts and investors, and Mr Fink said that the sheer scale of the inflows should be watched.

“It’s something everyone should be focused on, as there are extraordinary flows going into an illiquid asset class,” he said. “But if you have a client base with longer-dated liabilities you can have a higher percentage of illiquid investments.”

Beware the Fed’s Feedback Loop in Emerging Markets

Many countries’ economies look healthier because of volatile investment flows, not real economic progress

By Jon Sindreu

The Federal Reserve’s shift away from raising interest rates has once again driven investors toward juicy returns in emerging markets. They need to be careful of a dangerous feedback loop: The very fact that money flows into these countries makes them look safer.

Fed Chairman Jerome Powell doubled down Wednesday on his new wait-and-see approach to monetary policy. This will prolong the good times for emerging markets, where stock markets have returned 2.8% over the past six months, compared with a 1.2% loss for all stocks globally, according to the respective MSCI indexes. Currencies in countries with high rates have also rallied more, pointing to speculative yield hunting.

Developing economies are looking impressively resilient, especially considering worries about a China-led global slowdown. Earnings expectations have stabilized and investors seem to have decided that the sharp selloff in emerging-market assets last summer had more to do with isolated problems in Turkey and Argentina than broader concerns.

A welder at a factory in Nantong, China.
A welder at a factory in Nantong, China. Photo: str/Agence France-Presse/Getty Images 

The problem is that investors’ confidence could be creating a deceptive sense of calm. This will suddenly reverse if the dollar appreciates or cash flows out.

Two papers recently released by the Basel-based Bank for International Settlements highlight new evidence of this effect. First, by looking at a database of nonfinancial firms in Mexico, the BIS found that corporations tend to do the same as international investors when the U.S. dollar is weak: They borrow in greenbacks at low rates to lend in pesos at higher yields, and pocket the difference.

Their aim isn’t usually to speculate, but to extend trade credit to partners with less access to global capital. Still, the need to preserve these business relationships means that, when the dollar strengthens again, companies tend to offset losses by slashing investment rather than closing the credit taps, researchers found. This means that bouts of currency volatility—like last summer’s—likely damage these countries’ long-term productivity growth.
The research flies in the face of the economic-textbook idea that weaker currencies improve poorer countries’ chances because their exports get cheaper.

A second piece of BIS research, released this week, found that sovereign-debt investors in emerging markets tend to demand less compensation when the dollar is weak, even when buying bonds in local currency.

This is shortsighted: A weak dollar boosts credit to emerging markets, making them look stronger than they are. Investors often don’t give enough weight to this, mistakenly attributing both economic improvements and crises to local political developments rather than the ebb and flow of global capital.

Right now, investors are happy to clip their coupons, lulled by the Fed’s dovish mood music.

But they should be less blasé about the risks of a weaker-than-expected global economy and the return of a stronger dollar.

George Soros famously dubbed “reflexivity” the phenomenon whereby markets are subject to feedback loops between sentiment and reality. Volatile exchange rates make emerging markets particularly extreme examples.

German Defense Spending Is Falling Even Shorter. The U.S. Isn’t Happy.

By Katrin Bennhold

The NATO secretary general, Jens Stoltenberg, with German soldiers last October in Norway.CreditCreditJonathan Nackstrand/Agence France-Presse — Getty Images

BERLIN — Germany, which had already announced that it will fall significantly short of NATO’s defense spending goals, annoying the United States, risks provoking Washington further by failing to reach even its own slimmed-down target.

Chancellor Angela Merkel’s government had a falling-out with the Trump administration last year when it said that, despite signing a commitment to work toward spending 2 percent of gross domestic product on defense by 2024, its target would instead be 1.5 percent.

Now, projected spending levels are expected to fall below even that lower path in a three-year budget plan due to be announced on Wednesday, portending another confrontation with Washington.

The timing could not be worse, with NATO preparing to celebrate its 70th anniversary in Washington in April.

Mr. Trump’s resentment toward European allies he perceives to be coasting on America’s security guarantee is well known, and recent reports that Washington is considering billing allies for hosting American troops has further shaken the alliance.

Even in Europe, some diplomats in neighboring countries privately complain that Germany’s failure to meet its commitments is putting not just its own relationship with Washington on the line, but that of the whole Continent.

Ms. Merkel insisted on Tuesday that her government could still hit the 1.5 percent target in budgets down the road. But few still believe her — least of all Mr. Trump’s ambassador in Berlin.

“NATO members clearly pledged to move toward, not away, from 2 percent by 2024,” Richard Grenell, the American ambassador to Germany, told reporters on Monday after budget numbers were first floated. “That the German government would even be considering reducing its already unacceptable commitments to military readiness is a worrisome signal to Germany’s 28 NATO allies.”

With Mr. Trump calling the European Union a “foe” and NATO “obsolete,” trans-Atlantic relations have been badly strained for some time.

But in recent months, the tone has become openly hostile, especially between the United States and Germany, Europe’s largest economy.

Mr. Grenell has demanded that Berlin scrap Nord Stream 2, a planned gas pipeline from Russia, or risk possible sanctions for the companies involved; stop German companies from doing business in Iran, or risk restrictions on doing business in the United States; and ban a Chinese company from building a new communications network, or risk losing access to some intelligence sharing.

The threats have not gone down well in Berlin, with one German politician this week even demanding Mr. Grenell’s immediate expulsion for interfering in Germany’s sovereign affairs, although that is unlikely to happen.

“Any U.S. diplomat who acts like a high commissioner of an occupying power must learn that our tolerance also knows its limits,” said Wolfgang Kubicki, deputy chairman of the opposition Free Democrats.

The Social Democrats, Ms. Merkel’s center-left coalition partner, have put Mr. Trump’s scowling oversize face on a campaign poster ahead of European parliamentary elections with the caption: “Trump? Europe is the answer.”

Mr. Stoltenberg with the German chancellor, Angela Merkel.CreditAndreas Gebert/Reuters

But even some of Mr. Trump’s fiercest critics say that Germany’s failure to live up to its NATO spending commitments has given a hollow ring to the country’s vocal defense of the international order.

“You can’t have it both ways,” said Julianne Smith, a former adviser to the Obama administration who is currently in Berlin as a senior fellow at the Robert Bosch Academy.

“You can’t at every turn stress the importance of multilateralism and keep it as the foundation of German foreign policy,” Ms. Smith said, “and then renege on the commitments you’ve made to multilateral institutions like the NATO alliance.”

“I appreciate that Donald Trump has made it more difficult,” she added. “It’s become a liability to stand shoulder to shoulder with this guy.”

But she and others point out that Germany had committed to moving toward the 2 percent target long before Mr. Trump’s election — most memorably in 2014, shortly after Russia annexed part of Ukraine.

“Any German who frames this as bending to Trump’s wishes is missing the broader point,” Ms. Smith said of NATO’s 2 percent target.

German officials point out that in absolute terms, German military spending has increased for five straight years, up 36 percent, and that Germany is NATO’s second-biggest contributor of funds and troops. They say that a fair measurement of a country’s contribution to NATO should take account of wider factors, including foreign aid spending and the rate of economic growth.

Given the size of Germany’s economy and years of consistently high economic growth, 2 percent of G.D.P., some also argue, was a fast-moving target — and one hard to meet in a short period of time.

But many security experts have questioned that argument.

“We are just not credible anymore,” said Jan Techau, director of the Europe Program at the German Marshall Fund in Berlin. “First we said 2 percent, but we didn’t really mean it. Then we said 1.5 percent, and it turns out we didn’t really mean that either.”

Defense spending is still on course to increase next year, rising from 1.35 percent of G.D.P. this year to 1.37 percent next year, finance ministry officials said. But by 2023, according to the latest budget figures, it is expected to be back at 1.25 percent.

The latest trans-Atlantic conflict is in part rooted in Germany’s domestic politics.

The finance minister, Olaf Scholz, who drafted the new budget plan, is a member of the Social Democrats, the center-left coalition partner of Ms. Merkel’s Conservatives. Ahead of a string of European and regional elections this year, the Social Democrats, whose poll ratings have plummeted in recent years, are eager to distinguish themselves by giving priority to social spending over defense.

Some political leaders like Michael Grosse-Brömer, the conservative caucus whip, said that Parliament was expected to approve a continuation of its current military missions in Afghanistan, Mali, South Sudan and the Mediterranean, and that Germany still intended to uphold its spending commitments to its NATO partners. But he, too, conceded that “the current plan looks somewhat different.”

One wild card is economic growth, which is set to slow in coming years, making it easier to increase defense spending as a percentage of G.D.P. The German Council of Economic Experts scaled down its growth forecast for the current and coming years to 0.8 percent and 1.7 percent, respectively, saying that “the boom years are over.”

But it is time for Germany to look beyond electoral horizons and consider defense spending in a longer-term, strategic framework, said Ms. Smith, the former Obama adviser.

“Imagine Trump left NATO tomorrow,” she said. “Imagine the investment Germany would have to make in its own and Europe’s security then.”

“This is the cheap version,” she said of the current NATO spending targets.

Christopher F. Schuetze contributed reporting.

SEC to examine competition among US asset managers

Regulator fears that industry consolidation will hit investor choice

Chris Flood

Dalia Blass said the SEC would look at whether technologies such as blockchain could improve access to fund distribution for small and midsized managers (Capital Insights)

The US financial regulator is set to examine whether investors’ choice of asset management companies will be damaged by competitive pressures that threaten to destroy smaller players.

The fight for survival in the fund industry is driving merger and acquisition activity, with many small and midsized managers seeking to forge alliances.

This situation is of concern to the Securities and Exchange Commission, which will begin an investigation this year.

The SEC wants to see if any barriers exist that make it harder for small and midsized companies and whether these can be addressed without sacrificing investor protection.

“I am concerned about what it will mean for investors, particularly main street investors, if the variety and choice offered by small and midsized asset managers becomes lost in a wave of consolidation and fee compression,” said Dalia Blass, director of the division of investment management at the SEC.

Ms Blass was speaking on Monday in San Diego, California, at a conference hosted by the Investment Company Institute, the trade association.

As many as a third of managers could disappear over the next five years, according to Marty Flanagan, chief executive of Invesco, the Atlanta-based asset manager. “The strong are getting stronger and the big are going to get bigger,” said Mr Flanagan in a recent interview with the Financial Times.

A price war raging among US asset managers has led to the cheapest mutual funds winning an increasing share of new business.

BlackRock and Vanguard, the largest asset managers, have spearheaded price cuts with their low-cost index-tracking funds attracting record inflows. Last year, the big two together grabbed more than half of global net new inflows into long-term mutual funds.

Fees have been driven down as a result of competition for the business of institutional clients and the bargaining power of large distributors selling funds to retail investors.

Many distributors have culled funds from their platforms as investors shifted to low-cost index trackers.

Five of the eight leading US distributors have rationalised shelf space by dropping 4,900 funds in the past two years, according to Deloitte, the financial services provider.

Ms Blass said the SEC would look at whether technologies such as blockchain could improve access to fund distribution for small and midsized managers.

The SEC may also set up an advisory committee to take a broad view of asset management issues. This could look at the effect of indexing on markets, common ownership, the consequences of the scale of investment management companies and the participation of funds in markets historically associated with banks and brokers.

Ms Blass said that while an advisory committee could not answer every question it would lend “transparency, engagement and rigour” to industry debates.

Her speech highlighted other priorities for the SEC in 2019. The finalising of new rules for both exchange traded funds and fund of funds has a “high priority” for the SEC. It will also seek public comments on proposals for the reform of business development companies and closed-end fund offerings.

Ms Blass said the SEC anticipated that it would publish proposals for modernising the advertising and solicitation rules for investment advisers as well as a proposal on the use of derivatives by investment companies.