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Thoughts on etf dangers in a bear market

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Hi Cullen,

I appreciated reading your column on etf danger in a bear market. Its a topic my trader friends and I have discussed. I would respectfully suggest your column focuses on the wrong aspect of this issue. You seem to focus on selection criteria for index stocks as a non-issue, but I don’t think most view that as the source of the problem in the first place.

The source of the problem as we see it, is the crowding of money into specific indexes/stocks. If a higher concentration of total market cap is represented by a smaller number of stocks, then the unwinding of that trade may be more violent than in the past. The data on active vs passive is interesting but doesn’t necessarily compare the same outcomes. if the active managers in 2001, ’02, ’08 were in a different set of stocks than the index itself, then a comparison to the next crash in which a much higher percentage investors are in all the same index/stocks may not be valid.

Assuming the article you linked to is accurate, one company’s ETF’s represent 6.9% of the total S&P market cap. Thats nuts. Then add up all the other S&P index and sector funds. The SPY alone is over 1% of the total index market cap.

So what happens when that trade gets “unwound” in the next market crash? To answer that question I think you need to look at concentration of stock assets between periods of time, rather than selection criteria of the S&P index. We know the number of public companies has decreased substantially since the last crash and index ETF investment has skyrocketed.

So its likely that the concentration of investments in the S&P 500 stocks has increased compared with prior pre-crash periods. If true, that would likely result in a more violent downmove as investors withdraw from index funds. if this isn’t true, then you’re right, we probably don’t have to worry about so many people during into index etf’s.

This comment references http://www.pragcap.com/are-etfs-and-index-funds-more-dangerous-in-a-bear-market/

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Posted by Rob Levy
Posted on 08/05/2017 12:18 PM
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Hi Rob,

Thanks for the thoughtful comment. The trade doesn’t get “more crowded” because of the ETF. The owners of the ETFs are still individual owners and not one concentrated set of owners. If they execute trades to reduce the price of their shares in a panic then this impact will be the result of millions of different owners all doing the same. So, I wouldn’t think of ETFs as concentrating a trade. Yeah, if this was a hedge fund collecting all these assets with one manager making the moves then that would concentrate all of this. But an ETF just represents some other entity or person’s ownership. So it’s not like one ETF owner with a 6.9% stake is going to decide to dump SPY all at once.

But I would argue that you’re onto something slightly different. What ETFs do is sometimes give people a false sense of security. For instance, we have all these new robo advisors and similar managers who are running pretty aggressive stock heavy portfolios and telling their clients just to sit through any downturn. Well, that’s easier said than done and the robos, for instance, have no buffer to control reallocation at the client level. So if millions of robo investors decide to dump their stocks then they just have to click a button. In other words, you have a lot of people who are overweight stocks in naive strategies thinking they’re not taking that much risk and the next time the market dumps in a big way they might recognize how much risk they’re taking and compound the downturn.

– Cullen

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Cullen Roche Posted by Cullen Roche
Answered on 08/05/2017 5:19 PM
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    Isn’t the point about behaviour during a decline of the sp500 just that if some market participants hold shares that are’t in the sp500 then there may be some people who are up or un affected , during a decline in the sp500 , but if everyone is in an sp500 etf then there is no-one, who will be up , in an sp500 bear market.

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    Posted by Dinero
    Answered on 08/10/2017 12:55 PM
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      @Dinero In what fantasy world will you have the S&P down, say -25%, but a stock not in the S&P 500 is not relatively decimated as well? Correlations all go to 1 when people pull a FUD (fear, uncertainty, doubt) except in risk-off assets.

      Cullen’s got a good point about ETF’s being sort of a transparent shell that can’t be fat fingered into a collective sell. But the authorized participants that are responsible for buying/selling the stocks in/to the ETF are also very human. That’s the weak link.

      Basically, Rob is asking if the volatility of widely-held stocks in ETFs will be higher than without in downturns. I think there’s a couple of papers written about that issue.

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      Posted by MachineGhost
      Answered on 08/12/2017 9:01 PM
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        ETFs add to liquidity if anything because they force the authorized participants to make a market in a position that otherwise wouldn’t require market making. The ETF itself can appear illiquid if the underlying is illiquid, but that’s going to happen no matter what.

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        Cullen Roche Posted by Cullen Roche
        Answered on 08/14/2017 5:29 PM
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