Money and the Shared Economy

uber taxi1Ride-sharing apps, like Uber, are changing the taxi industry. Smartphones connect people who want rides with people who want to drive them. Uber is a high-tech middleman that is making the old intermediaries obsolete. Uber, Airbnb and others are creating a huge expansion of the “sharing economy.” No surprise, it’s spreading to banking and investing, where the real money is.

The old method of buying a house was to contact an agent to show you around. Now, we use the Web to find homes, research prices and take some virtual tours. However, we still generally use (and pay) agents to consummate the deal and, worse yet, still have to deal with archaic loan procedures at the bank. That’s likely going to change.

Zachary Karabell in the WSJ on November 6th provided his concept of the “uberization” of the loan process. “Imagine instead a simple online interface that could generate a tailored credit score for you, taking into account your future earnings potential based on your education and location. It would connect you with lenders ranging from banks to credit unions to pools of individuals who would want to lend privately at a negotiated rate for whatever duration you agree on. You could shop around, combine different types of financing and arrange a mortgage package that suits you, all within a few hours.”

While financing may not evolve exactly as Mr. Karabell envisions, it certainly is going to change. Technology has spawned the shared economy. Legislation will help its proliferation. The JOBS Act of 2012 made it easier for startups to raise money. And, now the SEC has approved rules, going into effect early next year, that will allow any company or individual to raise up to $1 million without any of the regulatory or reporting requirements as in the past.

Peer-to-peer lending should see a huge increase. Thousands of years ago, people with money would lend it to those who wanted to borrow it.   That is returning. Pools of small lenders can combine online to make small loans. And, they can do it without a middleman, such as a bank, and with much less up-front cost or regulations. Peer-to-peer lending already accounts for $7 billion in loans. PWC expects that amount to increase to $150 billion by 2025. The convenience of peer-to-peer borrowing, particularly for smaller loans, is especially attractive for millennials. However, at least initially, the rates will likely be higher.

Peer-to-peer lending and other shared economy measures may help boost the economy. Last night’s Republican debate included a number of candidates lamenting the small amount of business start-ups. One of the issues confronting potential new businesses today is tight credit. Federal Reserve surveys of bank loan officers indicate that current credit standards are tighter today than before the financial crisis of 2008-2009. It may be prudent for the banks, but it has certainly reduced new business formation.

As a result, new “crowdfunding” sites such as Kickstarter and Indiegogo have done very well. These sites could be described as the “Wild West” or “Vegas” sites, where almost anyone can announce an idea and solicit money for it for $1,000 or less. These contributions are donations. However, the next wave will offer equity ownership for small investors.

The other big impact is on stockbrokers. Investors don’t need an expensive middle-man to make trades, particularly a stockbroker that has no legal responsibility to put their interests first. Roboadvisers, as we have discussed in earlier blogs, have shaken the brokerage community. They offer online asset allocation and investing services at a fraction of the traditional brokerage fees. While roboadvisers typically don’t provide comprehensive investment management and certainly don’t provide value-added services that a wealth manager does, they do provide an inexpensive solution for some young people and/or those do-it-yourselfers with small accounts.

It’s interesting to try to forecast what the world of money might look like 5-10 years from now. There is no question that many changes will continue, particularly those areas where middlemen, who provided little value and took a big fee, will be replaced. The shared economy principles are here to stay. For those focused on receiving and providing value at a fair price, it’s all good news.

WSJ: “Actively Managed or Index Funds? Why Not Both?”

passiveactiveicecreamWe agree. We’re not alone. A recent WSJ survey showed that 42% of investors own both active and passive funds, while 36% own only actively managed funds and 22% own only index/passive funds. Some investors swear by index funds and some love only active management. It really shouldn’t be an either or decision.

Use indexes/passive funds for efficient markets. As the Economist pointed out in their February 22nd issue, “The costs of actively managed funds are higher than most investors realize”. Think of it, an active fund needs to do research, make lots of trades, spend lots on marketing to “sell” their strategy and therefore, their cost of operations can be 1.50% or more. An index fund merely replicates an index and cost can be as low as .05%. Is it any wonder that 60%-80% of actively traded equity funds fail to beat their market index each year? And, 60% to 90% of actively traded fixed income funds fail as well. Why? Active management has to overcome high fees, transaction costs and tax ramifications.

Expenses matter. A 1% difference in performance over long time periods can really add up. $100,000 invested that earns 6% for 30 years grows to $574,000. At 5%, it only grows to $432,000; a 25% reduction.

We believe that traditional capital markets work and price securities fairly. Despite what the financial press and fund marketing literature suggests, study after study shows the majority of active managers underperform. So, yes, passive/index funds are superior to active funds for equity and fixed income- traditional efficient markets. But, what about non-traditional inefficient markets?

Use actively managed funds for inefficient markets. The last two decades have seen a great proliferation of investments that are not correlated to the stock market. Many are publicly traded and easily redeemable. They often follow hedge-fund like strategies designed to reduce volatility. These liquid alternatives may include arbitrage funds, global tactical allocation funds, closed-end specialty funds, MLPS, and long/short funds. Studies have shown that adding non-correlated assets to a portfolio can improve return and reduce volatility.

These actively managed alternative funds will typically have an operating expense ratio in the 1-2% range. This is understandable. They do considerable research. Their trading costs are often higher due to the use of derivatives and lots of trades. And, yes, they have marketing costs to educate and inform prospects and clients. One benchmark for these funds might be an “absolute return” of 1-6% above LIBOR.

“Use a mix of passive and active funds to bring down overall expenses and to hedge against market crosscurrents” was the conclusion of the WSJ article March 4th. Again, we agree. The bulk of a portfolio, equities and fixed income, should be in index/passive funds, with a weighted average operating expense of perhaps .35% or lower.

Passive and active funds perform differently in various market conditions. While stocks were up 30% last year, fixed income did poorly and a basket of liquid alternatives we follow had an absolute return of 4%. Then, in January, when stocks lost 3-4%, fixed income rebounded and this basket of liquid alternatives was slightly positive. In short, a nice blend of passive and active funds is designed to help investors participate in the upside of markets and protect in down markets. And, because DWM is committed to protecting and enhancing our clients’ net worth and legacy, that works well for us and our clients. Very well, indeed.