How did ETFs function during the 2020 market sell-off and did the indexing bubble burst? which ETF structures failed the stress test and which passed?
Topics covered include:
- Why were some investors, like Michael Burry, concerned about an indexing bubble
- What are ETF risks such as flash crashes
- How did equity ETFs function during the spring 2020 sell-off and how they can act as shock absorbers
- What were some of the challenges that bond ETFs faced in March 2020
- How the rise in bond ETFs is leading to changes in how bonds are traded
- Why leveraged ETFs and oil-linked ETFs failed the stress test
- What caused the dysfunction in the U.S. Treasury market in March 2020
- What are the advantages of ETFs and why they are still a good product for long-term investors
Show Notes
ETF backers declare victory after ‘largest ever stress test’ by Robin Wigglesworth—Financial Times
ETF growth is ‘in danger of devouring capitalism’ by Robin Wigglesworth—Financial Times
ETFs, born from 1987 market crash, are so far making 2020 less awful by Andrea Riquier—MarketWatch
HIGH VELOCITY MARKETS: A case study on U.S. exchange-traded product performance during the week of February 24, 2020—iShares (URL no longer available)
All that drama about fixed-income ETFs was overplayed by Robin Wigglesworth—Financial times
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 311. It’s titled, “Did ETFs Pass the 2020 Market Collapse Stress Test?”
Last week LaPriel, my daughter, and I were in Red Lodge, Montana, we had been camping, and we wanted to order some takeout food. We found an Italian restaurant. I called to order our meal and the individual that answered asked if he could put me on hold. I said “sure.” 7 minutes later I was still on hold. There was no hold music, he had put the phone down and I could hear people in the background talking.
I finally got so frustrated, I drove to the restaurant still on hold and walked in. And said, “hey, I’m the guy on hold.” He was somewhat apologetic, said he had been delivering some food. The restaurant was empty, maybe there was some seats outback. So I tried to place my order. I wanted to order some pizza. He said, “we don’t have any pizza today, we’re not making it.” The last time I was in a pizza restaurant that didn’t have pizza was in Cuba and they actually told me why. They said they had no cheese. I tried to order the vegetarian lasagna. “We’re not doing vegetarian lasagna today,” he said. At that point, I gave up and left.
It’s important that businesses and financial instruments be tested. And be given feedback when their processes aren’t working well. Sometimes it’s called a stress test. Now in the case of this restaurant, I thought, since I was on hold so long, that they were under stress. So it would be helpful to provide feedback. No, the restaurant was empty.
Indexing and Equity ETF Worries
This year we have definitely had some stressed financial markets. And there were predictions that some financial instruments would not perform well in a stressful environment when there are many sellers trying to exit. Micheal Burry is a hedge fund manager that was featured in the movie and book The Big Short. He predicted the subprime crisis of 2008.
Last September 2019 in an interview with Bloomberg, he said, “Central banks and Basel III,” which is the banking regulation that we talked about a few episodes ago on “Are Banks Safe?”, “have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in the interest rates anymore. And now passive investing has removed price discovery from the equity markets.”
I discussed this in Plus episode 268. And a member wrote to me that did a great job describing what Burry’s concern is. He wrote, “Burry thinks that the low volume stocks within an index are relatively illiquid. When an index ETF wants to create new ETF shares it has to bid up the price of a low volume stock in order to create the ETF shares. That is the index fund is artificially supporting the price of the low volume stock. The reverse is true when an index fund or ETF eliminates it’s shares. It must sell the low volume share into an illiquid market. It must receive relatively less for the share if they are obliged to sell. Burry points out that index funds are forcing capital into a segment of the market that cannot really absorb it and thus the prices are disconnected from the true value of the stock” That was Burry’s concern. He was not alone.
Paul Singer, founder of Elliott Management, a hedge fund, said “Passive investing is in danger of devouring capitalism. What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth creating and consensus prospects of free-market capitalism.” Capitalism being the process of allocating capital efficiently.
Inigo Fraizer Jenkins, a senior analyst at the research firm Bernstein, in a 2016 client note said passive investing was “worse than Marxism because communists at least tried to allocate capital efficiently.”
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