Back in March, Howard Marks offered [13] the following rather straight-forward assessment of exchange traded funds: "The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid."
That’s a warning that almost no one seemed to understand.
Well, that’s not entirely true.
Some ETF providers clearly understood because, as we noted with some alarm in May [14], Vanguard, Guggenheim, and others are quietly lining up billions in emergency liquidity that can be tapped in the event IG and HY bond fund flows suddenly become very non-diversifiable (aka unidirectional, aka everyone is getting the hell out in a hurry).
The problem, without subjecting readers to the entire backstory (which you can read here [15]), is that thanks to lawmakers’ futile attempt to root out prop trading, dealers aren’t willing to hold any inventory anymore and so secondary market depth in corporate credit has collapsed, meaning the potential exists for large trades in the underlying to cause severe price distortions.
But while everyone focused squarely on corporate bonds funds and the potential for ETFs to exacerbate the problem by giving retail investors the illusion of liquidity when in fact, the underlying is extremely illiquid, not many people seemed to be aware that the very same thing could happen to equity ETFs should liquidity dry up in the underlying stocks.
Two points on this, i) Howard Marks’ assessment applies equally to equity ETFs; that is, the ETF cannot be more liquid than the underlying, and ii) thanks to today’s broken markets, there’s the very real potential for liquidity to suddenly disappear in stocks.
Well, anyone who headed into last weekend still harboring the patently ridiculous idea that somehow exchange traded funds can be more liquid than the assets they reference was subjected to a terrifying dose of reality on Monday morning when suddenly, amid a 1,000 point decline in the Dow, determining NAV became all but impossible in the flurry of tripped circuit breakers and flash crashing mayhem leading to epic and apparently un-arb-able disconnects between fair value and the ETF units.
As we noted in our Black Monday post-mortem [16], the ETF carnage was so readily apparent, that even CNN felt compelled to weigh in [17] with the following:
The circuit breakers were implemented more than 600 times on ETFs, the increasingly-popular securities that trade like stocks. ETFs hold a basket of stocks, removing the risk of betting on a single company. ETF.com examined the pricing action and discovered at least eight ETFs that showed "flash-crash" style drops at the opening of trading.
ETFs that experienced panic selling are far larger and wouldn't be expected to have that kind of turbulence. For example, the iShares Select Dividend ETF (DVY) plummeted as much as 35% at its lows.
That's a stunning move considering this BlackRock (BLK)-backed ETF is worth over $13 billion and is focused on stable American stocks that have a long history of paying dividends.
None of this ETF's top holdings -- like Lockheed Martin (LMT), Philip Morris Internationa (PM)l and McDonald's (MCD) -- suffered losses north of 11%. It was even worse for the Guggenheim S&P 500 equal weight ETF (RSP). The $10 billion fund, which holds some well-known stocks like Chipotle (CMG) and ConAgra (CAG), plummeted nearly 43% at one point on Monday.
In short, when it came time for liquidity providers and market makers to, well, to provide liquidity and make markets, nobody was home, or, as we put it on Tuesday, "anyone who actually trades (and is not part of the Modern Market initiative) knows that this precisely what happens every time there is a spike in market vol: HFTs simply walk away leading to the dreaded 'HFT STOP' moment, creating a feedback loop of even less liquidity, and even more volatility, until circuit breakers are finally hit or asset prices hit limits."
For ETFs, this apparently created a situation where the idea that, when we look at bid-asks, liquidity has never been better, went completely out the window. As the CEO of one Connecticut-based asset management firm told WSJ [18], "when market makers have no clue, they’re going to widen up the bid/ask spreads, then an investor puts in a market order and a market order like that is asking the market maker to take advantage of them, which they did."
The result? 220 ETFs fell by at least 10% on Monday:
[19]
Here’s a further attempt by WSJ [20] to get to the bottom of what happened:
When the market sold off in the first six minutes of trading, many stocks were halted after triggering circuit breakers, including stocks that are included in popular exchange-traded funds.
Because this happened so quickly, many ETF market makers, or the broker-dealers who buy and sell those products, were unable to accurately calculate the value of the underlying holdings or properly hedge their trades. That caused them to lowball their buy offers and overprice their sell orders to ensure they didn’t take on too much risk. This sent ETF market values tumbling, too, and caused disruptions in the trading of other assets.
In order to protect their positions, when market makers buy ETF shares, they often sell the shares of an ETF’s holdings as a hedge. The price of ETFs is a derivative of the underlying stocks it represents, so this allows them to mitigate some of the risk. The number of trading halts in underlying stocks made this type of hedging impossible, traders said. Unable to properly hedge, they traded less because it was too risky, they said.
And so on. But as we noted in the aftermath of the chaos, Themis Trading's Joe Saluzzi probably put it best when he simply said that "somewhere along the way, the ETF pricing model was broken today."
Yes, it sure was, and the bottom line for retail investors who have for years been led to believe that somehow - despite the fact that it defies all logic and flies right in the face of common sense - a vehicle that aggregates assets can somehow be more liquid than the assets themselves in a pinch.
We would of course caution that this is just the beginning and we wonder if Monday's experience will will be the last straw for a retail crowd which, as was communicated quite effectively by reader "Ryan M", a millennial whose open letter to CNBC [21] we published earlier this week, no longer wants anything at all to do with America's once proud capital markets that, thanks to a noxious combination of central planning and vacuum tube manipulation, now trade like those of a banana republic.
And on that note, we'll leave you with the following short account from WSJ which vividly demonstrates what can happen when you do not endeavor to comprehend Howard Marks' warning about ETFs and what we call "phantom liquidity":
Ted Feight, a financial planner in Lansing, Mich., had an order in place to sell all of his clients’ exchange-traded funds if their prices fell 15% from their peak this year.
Monday morning, that’s exactly what happened. As stocks tumbled at the open — the Dow fell as much as 1,000 points, or more than 6% — almost every ETF he had was sold, he says.
Had the ETF prices tracked the market, the order Mr. Feight had in place would never have triggered the sales of most of those ETFs.
