One of the horses we have beaten to death starting in 2013 (with Why The TBAC Is Suddenly Very Worried About Market Liquidity) is that the relentless growth in ETFs in particular, and passive investing in general, is one of the greatest threats facing the US equity market for one main reason: “phantom liquidity”, and specifically the thought experiment, conducted back in March 2015 by Howard Marks, of what happens if and when the ETF selling begins.
This is what we said one week ago:
The relentless growth of passive investing in general, and ETFs in particular, has been extensively discussed on the pages over the past few years, most recently overnight when we presented a note from Convergex which laid out some ideas how investors can profit from the unstoppable – for now – shift from active, and expensive, management to cheaper, passive forms of asset allocation. Others, such as One River’s Eric Peters gave a decidedly more downbeat outlook on what the creeping growth of ETFs means for capital markets and price formation, warning that “there is no such thing as price discovery in index investing. And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold.”
That simplified analysis touches on the biggest threat facing ETF investors: namely “phantom liquidity” of what has effectively become the market’s biggest quasi-derivative product. In a nutshell, the threat here is that what is traditionally considered to be the market’s most liquid instrument, would be unable to satisfy a massive redemption wave due to a huge liquidity mismatch between the synthetic product, the ETF itself, and its underlying instruments, particularly in various types of debt ETFs.
The head of the BOE Mark Carney himself has warned about the risk of “disorderly unwinding of portfolios” due to the lack of market liquidity.”
“Market adjustments to date have occurred without significant stress. However the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia,” Carney told a news conference after a meeting of the FSB.
“As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”
And then there was, of course, Howard Marks, who mused in his “Liquidity” note:
ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity?
Now, in addition to the persistent liquidity threat from ETFs, we can add two more troubling concerns about ETFs: in addition to making markets more illiquid and discontinuous (recall August 24, 2015), a new scientific study has found that exchange-traded funds also make markets dumber… oh and more expensive.
That, as Bloomberg notes, is 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.
While it will hardly come as a surprise to traders who notice the pattern every single day, there is now scientific proof that of the phenomenon that stocks eventually turn into drones that move in lockstep with their industry. As Bloomberg points out, 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.
“ETFs are clearly an important development in financial markets, which have brought many well-documented benefits to investors,” researchers Doron Israeli, Charles Lee and Suhas Sridharan wrote in a paper last month. “Our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities.”
What the study found is that a single percentage point increase in ETF ownership has demonstrable effects on an individual stock. Over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9 percent, while the relationship between its price and future earnings falls 14 percent. Meanwhile, bid-ask spreads rise 1.6 percent and absolute returns grow 2 percent.
The cause? Unsophisticated investors and the ways they buy securities.
Before index funds, Bloomberg adds, traders who thought they knew something others didn’t could turn a profit in transactions with less informed buyers of individual stocks. That disadvantaged cohort now buys ETFs, locking up securities that traders once could pick off when price discrepancies arose.
The detrimental effects to the market snowball from there. Fewer trades occur, so liquidity in single stocks deteriorates, raising transaction costs. That only further discourages professional traders, so the price discrepancies remain without the informational arbitrage to close the gaps.
Making matters worse, the reduced interest in individual equities also results in less analyst coverage, the researchers argue.
To be fair, this is not the first time proof was demonstrated that tighter correlations and a dumber market are a consequences of index fund. In fact, as Bloomberg adds, it is well trodden territory in doomsday ETF literature. A Virginia Tech paper in 2014 found that fewer signals about corporate performance seeped into prices over time because of passive investing. Instead, the investors arrive all at once when earnings results are disclosed.
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Incidentally, in a separate report posted over the weekdn by Goldman Sachs, the firm found that “unabated passive growth” and index investing has lead to “suboptimal allocations for capital.” This is what Goldman reported on the issue:
- Passive investing, led by ETF growth, has delivered superior returns at lower fees (in many cases) than active managers over the last decade. If the best measure of success in an investing world is performance (return per unit of risk) one other indicator would be AUM growth. Indeed the growth in these products, as seen below, has been unabated.
- With the runaway growth of these products we ask if following an index is the optimal allocation for capital. Namely we run an analysis juxtaposing the ROIC v WACC of the S&P 500 by weights of the underlying stocks. We find that it is not.
- FOMO. For market cap weighted instruments concentration of securities drives the need to not to stray too far away from benchmarks given the fear of missing a larger weighted name’s performance.
Obviously, the allegation that the market has become a more inefficient allocator of capital is simply another way of saying it has become dumber.
And all thanks to the Fed, which as we showed earlier this week is the primary cause for the “deplorable” returns by the active community, and hedge funds in particular.
Of course, as long as the general direction of the market is higher, all inefficiencies that have developed are masked by the proverbial “rising tide” but one day the selling will arrive, and what will make that particular sell off is that nobody has any idea how it will end.
We leave the parting word to Troy Draizen, global head of electronic trading at Convergex Executive Solutions, who said “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.” This time won’t be different.