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Caveat Investor: ETF Risk

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By Briar :

ETFs: The Innovation behind the next financial crisis

History might not repeat itself but it does rhyme. Robert Z. Aliber, emeritus professor of international economics at The University of Chicago and editor of the last two editions of Charles Kindleberger's Manias, Panics, and Crashes : A History of Financial Crises, has noted that an innovation is at the root of every financial crisis. So where is the rhyme? In the '87 crash it was portfolio insurance; in the Great Recession of '08 it was securitization. The obvious candidate for the next crisis is Electronically Traded Funds (ETFs). Why?

What is an ETF? It is a pool of securities whose shares are traded real time on stock exchanges. Buying a share of an ETF is like buying a share of a company. But like mutual funds they are diversified within an asset class, such as an ETF that mimics the S&P 500 index. Unlike a mutual fund that mimics an index, however, these shares trade during trading hours, while a mutual fund is effectively traded at the close of business each trading day at a price that equals the closing net asset value (( NAV )) of the fund. Thus, an investor inclined to time the market will be attracted to an ETF, because waiting until a price at the end of the day might result in a missed opportunity, in his or her mind.

Now into the weeds a bit more. ETF sponsors do not trade directly with investors. Investors buy and sell only with market makers or authorized participants. Each ETF might have some 30 authorized participants who together create a secondary market for the shares of the ETF, which investors buy on an exchange.

The ease of buying or selling shares of an ETF creates some risks. If orders to buy or sell greatly exceed what the market will bear the price of the ETF might diverge from the net asset value of the underlying assets. In such cases the authorized participants, in their role as market makers, arbitrage the difference. These efforts could lead to a sudden rise in market orders, which are information-less: they do not result from any specific knowledge of the securities being sold. Extreme situations could result in fire sales.

Two aspects make innovations ripe causes for mischief. First, they have force: dumb ideas are quickly discarded; good innovations provide purchase for the imagination, which is fueled by seeing others making money. (Kindleberger noted in an early edition of Manias, Panics, and Crashes that, in his experience, nothing disturbs a person more than the financial success of a neighbor.) Second, an innovation is new and untried, so the imagination is not tempered by adverse experience. Leading up to 1987, portfolio insurance was promoted as the vehicle to protect against stock market losses. It became popular among large investment operations.

But what might work for a single operation might very well become a disaster when many investors act at the same time: the idea was that you would sell futures to hedge a declining market. But what happens when everyone tries to do this at once, the market seizes and crashes: it did on October 19, 1987.

Two decades later, the Great Recession was fueled in large part by the widely accepted assumption that the securitization of mortgages made ownership of mortgages less risky: they were diversified by including many mortgages within a pool, and these mortgages were diversified geographically. And the rating agents stamped their approval. Congress, likely impressed by this innovation, too, also put pressure on Fannie Mae and Freddie Mac to increase home ownership by issuing questionable mortgages. These were entered on their books, yes, as "sub-prime". At the root was an untested innovation.

Leading up to 2008, investors and policymakers alike lulled themselves into believing that house prices only rise. Mortgage-backed securities were being bought and sold with little attention to the underlying mortgages. No one cared while house prices kept rising: the rising value of the collateral reduced risk, a house could be sold for more than the mortgage. But, alas, as the late Herb Stein famously said, if something can't go on forever it will stop. House prices not only stopped rising, they declined to the point that the value of a mortgage security depended on the ability of the homeowner to repay. Many couldn't and the collateral, the value of the property, no longer covered the mortgage.

Both the 1987 and 2008 crises exhibit the marks of an experiment many of us did in grade school. Remember mixing a slurry of cornstarch and water. Easily done, slowly! But what happened when you tried to stir too fast? It locks up solid. The stock market is a cornstarch and water slurry. If trading is moderate the market clears; but if everyone rushes at once for the exit, the market freezes or goes into free fall in search of buyers.

So why might ETFs be the next innovation in our rhyme? For starters, the concept of an ETF is a sound idea: they offer real-time trading and broad diversification. But it is untested: ETFs have yet to be exposed to a real-life stress test. Investors operate with the belief that they are liquid and tradable real time, and they are well diversified within their asset class. But how liquid are they really?

Howard Marks has made a persuasive case that an ETF is only as liquid as the underlying assets. What if those underlying assets can't be readily sold? What happens if investors suddenly find cause to press the sell button on their smartphone? Can those orders be refused? At some point the authorized participants-market makers-will be forced to liquidate a portion of the underlying assets in information-less trades. In other words, Sell, period. The result is a fire sale.

One might think that an S&P 500 ETF would be less susceptible to sudden illiquidity. But think of October 1987. And consider that the volume of the S&P ETFs, reportedly, far exceeds the volume one might expect if S&P ETF investors were mainly patient, long-term investors. It appears that many institutional investors use these ETFs to hedge positions. What would happen if this trading suddenly dried up or worse if these ETF positions were suddenly liquidated forcing the authorized participants to sell heavily the underlying shares? And let's remember that investors buy ETFs to avoid the need to study many businesses.

My gosh, The Efficient Market Hypothesis has taught us that studying 500 companies is a waste of time: the market knows everything already, so just buy the ETF! But this puts the average investor way outside his or her sphere of competence. We know what happens when investors know little or nothing about the underlying assets. Remember securitized mortgages? How reliable are your decisions when you know little about a matter? We lull ourselves into thinking that diversification gets us off the hook. But can we be sure that the slurry won't freeze up under extreme, not-yet-tested conditions? Mark Twain wrote (Pudd'nhead Wilson's Calendar): "Behold, the fool saith, 'Put not thine eggs in the one basket'-which is a manner of saying, 'Scatter your money and your attention'; but the wise man saith, 'Put all your eggs in the one basket and-WATCH THAT BASKET.'"

Pudd'nhead Wilson is wise. Modern finance and human nature have lead us to confuse volatility with risk of permanent loss. We prize diversification because it reduces volatility, but does that reduce permanent loss, particularly when we know little about the underlying assets? Ponder this: we can feel happily married to one person, but we own ETFs to be diversified. Should we trade in our spouses for a diversified ETF of woman- or manhood? (Don't worry, someone will create one for you!) With marriage we aim to make one good decision and hope it will last a lifetime-a bad one will take a minimum of two more to correct, so get it right the first time-and LEARN TO HANDLE VOLATILITY.

Warren Buffett observed long ago that one should only own a stock if one is prepared to have the price decline 50%, because sooner or later it will. Otherwise one risks the urge to sell at the worst time. My guess is that the majority of ETF investors are not prepared for prices to decline 50%, or less. The ETF has deluded investors into thinking that they are safe-and they can get out by pressing the sell button. I have posted a reminder on my wall: Don't do something; just sit there. It is hard to sit tight if you equate volatility with risk of permanent loss.

I began by stating that an innovation is at the root of a financial crash. That needs some clarification. It is not the cause of a crash; it exacerbates a crash. The cause is something else. Aliber notes that it is often a shift in foreign capital flows into the US. He thinks that shift has again happened, drying up the capital inflows buoying stock prices, and a significant decline is imminent. The innovation puts off the day of reckoning and, in doing so, exacerbates the reversion to the mean.

In 1987 the reversion to the mean was fast but short lived. Some investors faced margin calls, but little long-term damage occurred. I recall Milton Friedman at the time observing that the entire bond market gained more in value than the equity market lost. The markets soon re-equilibrated. In 2008 the entire financial market came close to freezing. The accounting requirement of mark to market greatly contributed to this. Suddenly nearly the entire market was marked to fire-sale prices. Well-established businesses were suddenly being priced at salvage value and no longer as going concerns.

Recently, billions of dollars have been flowing into all manner of ETFs. These inflows must surely be pushing up the prices of the underlying shares. What happens when these inflows stop? What happens when panic occurs?

This is not an article on forecasting an immanent crash. It is about being prepared. We read little about the potential systemic risk of ETFs, only about their convenience and low fees. The better prepared we are for the possibility of being blindsided, the easier time we will have of following the wise advice: don't do something: just sit there.

See also Investing In The Car Batteries Space on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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