There was a time when portfolio insurance guaranteed that events like Black Monday would never happen. Then Black Monday happened precisely due to portfolio insurance. Some years later, the credit-driven housing boom made modeling of declining home prices at rating agencies (and everywhere else) redundant. Then the (first) housing and credit bubble popped leading to the biggest housing market crash in US history. Fast forward to today, when ETFs were supposed to be the "greatest thing since sliced bread" and providing an ultra-low cost alternative to mutual fund and other market exposure "for the people", were supposed to revolutionize investing. Until days like yesterday. To wit from the FT: "The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicated for worst-case scenarios," said Bryce James, president of Smart Portfolio, which provides ETF asset allocation models.
Turns out yet another cost-cutting, computerized contraption was only as strong as its weakest link: which in this case turned out to be a completely unexpected, Bernanke-driven bond market sell off, which led to unprecedented stress in the $2 trillion ETF industry.
More from the FT:
A wave of selling caused many exchange traded funds to tumble below the value of their underlying assets as a bond market sell-off caused stress in the $2tn ETF industry.
ETFs track baskets of underlying assets, such as emerging-market stocks or municipal bonds, but discounts widened sharply on Thursday as dealers struggled to keep up with the sell orders.
Emerging-markets ETFs were among the worst affected, as investors took fright that the end of Federal Reserve monetary easing would lead to outflows from developing countries.
Please welcome the ETF gates:
The selling also caused disruptions in the plumbing behind several ETFs. Citigroup stopped accepting orders to redeem underlying assets from ETF issuers, after one trading desk reached its allocated risk limits. One Citi trader emailed other market participants to say: “We are unable to take any more redemptions today . . . a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out.”
State Street said it would stop accepting cash redemption orders for municipal bond products from dealers. Tim Coyne, global head of ETF capital markets at State Street, said his company had contacted participants “to say we were not going to do any cash redemptions today”. But he added that redemptions “in kind” were still taking place.
But don't worry: it's temporary: "Market participants described the heavy volumes and losses on Thursday as a rare occurrence"... although if it isn't "it could translate into further selling on Friday or early next week."
Then again, if the Plunge Protection Team - which was designed for precisely these kinds of interventions - does not step in, the entire ETF space could go up on a margin call musrhoom cloud. Going back to Bryce James: "The falls violated risk tolerance levels for many investors and if they were leveraged at all they are likely facing capital calls."
So keep calm and buy. Or else the fake and artificial wealth effect gets it.
Also perhaps it is time to inquire: if Money Market Funds were the straw that broke the post-Lehman camel's back, will that dubious distinction be handed to the ETF product the next time the global financial system is on the rocks and needs just one spark for the final collapse?