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.
This post was published at Zero Hedge on Apr 19, 2017.
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