I love ETFs. So do a lot of other people.
Who can blame us? All of the returns generated by the market, or a sector, or whatever the ETF tracks. Much lower fees.
It’s a winning combo, and the combo is winning over more and more people — and money — all the time.
Just look at the transfer of wealth from active- to passively-managed funds:
But I’ve started to worry about them. Specifically, what will happen to them if the market starts selling off at a fast rate.
Look at the date range on that chart. When the Great Recession was underway, the cumulative flow into ETFs was about a third of the levels we’ve seen to date.
A vast majority of the growth, and importance to the market, of ETFs has happened in a rising market. These products have never been stress tested beyond a couple market corrections.
When that stress comes — and it is only a matter of time, really — I’m afraid that a lot of people are going to be very surprised.
The safest and easiest way to invest when times are good may completely reverse and become a huge risk that is hard to unwind.
Making Markets Dumber
Extremely high market correlation should be familiar to everyone these days. The market is down, so your individual stocks are down the same amount.
This has always been a thing, but not as big of a thing as we’re seeing these days. Furthermore, on days when the market — or just the aggregate of a specific sector — drops, that correlation used to quickly fall apart.
That may not happen anymore, thanks to the amount of passive money being invested on behalf of ETF owners in their underlying stocks.
As Bloomberg reported 10 days ago, ETFs are making markets dumber, and more expensive.
“That’s the finding of researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel. They’ve uncovered evidence that higher ownership of individual stocks by ETFs widens the bid-ask spreads in those shares, making them more expensive to trade and therefore less attractive.
“This phenomenon eventually turns stocks into drones that move in lockstep with their industry. It makes life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals.
“The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds.”
The potential for traders with an information advantage of some kind to find value, or simply make a profit from someone else’s mistake, is greatly diminished.
The researchers found that for each 1% increase in ETF ownership of a stock caused over the next year:
- Correlation to the share’s industry group and the broader market goes up 9%;
- The relationship between its price and future earnings falls 14%;
- The bid-ask spreads to rise 1.6% and absolute returns grow 2%.
It doesn’t stop there. Liquidity drops, raising transaction costs and discouraging price discovery.
Liquidity and Discovery
Volume and liquidity are closely related, but don’t think they are the same.
Volume is the total amount of trades, nothing more. Liquidity is how the devil gets into the details.
A couple years ago, I read something from Citi’s Matt King that put this well. Here are his four dimensions of liquidity:
- Tightness: difference between bid and ask prices
- Depth: size of transaction that can be absorbed without affecting prices
- Immediacy: speed with which orders can be executed
- Resiliency: ease with which prices return to “normal”
The researchers mentioned before already established the negative effect on bid and ask prices.
Depth and immediacy can be rolled together when it comes to ETFs.
With money steadily flowing into ETFs through retirement accounts and fund transfers, there doesn’t need to be a whole lot of depth. People are just steadily buying into a product that is steadily rising in value.
That is exactly what investors want to see. But what happens when the ETF is forced to reverse the flow?
ETFs have to sell based on what their shareholders do. If you sell your stake in the massive S&P 500 ETF (NYSEARCA: SPY), it has to sell S&P 500 stocks as a result.
Now imagine that when everyone is selling SPY. Liquidity is almost always great until you really need it, and this is why.
The depth will never be sufficient for a quick sell off of ETF funds. Immediacy of trades will get blown up at the same time.
The result is an algorithmic trading death spiral. The trades that go through are valued at far less than when they were entered. More has to be sold as a result. Those take even longer as the bid and ask prices go haywire.
And since ETFs force individual stocks to stay in lockstep movements, there is no price discovery. There is no person or computer there to say “OK, sell stock X, but let’s hold onto stock Y because now it is severely undervalued.”
There never can be, because the ETF is purposefully designed to not allow anyone to do it.
Too Much Of A Good Thing
So ETFs encourage stock price movements to get locked together, makes them more expensive, and sets up a scenario where they could create a massive problem for ETF investors.
I still love them, but there is a point for everything where too much of a good thing becomes really, really bad.
Troy Draizen, global head of electronic trading at Convergex Executive Solutions, said it well: “ETF’s are a great innovation, but an over-population of any innovation could cause unintended consequences if left unmonitored. We have seen this in many market cycles, from dot-com to the credit crisis.”
Markets have shown this every time we were heading into a crash in the modern era. The current paradigm plays out until it collapses under its own weight.
And, though it may be a bit of a non sequitur, there are now ETFs of ETFs — the ETF Industry Exposure & Financial Services ETF (NYSEARCA: TEFT).
It reminds me of how derivatives of derivatives kept popping up towards the end of the credit bubble leading into the Great Recession. Make no mistake, ETFs are their own kind of derivative as well.
It is always the things you don’t worry about that end up biting you from behind. I’m going to be taking a closer look at liquidity in ETFs when the market gets choppy. You’ll probably hear more from me when I do.
In the meantime, I’d suggest taking a contrarian view to the boring, stable market we seem to have today. Don’t be lulled into complacency, and always consider the worst-case scenario.
