Over the last few years, as nervous investors worried about a market that has risen to record highs on trillions in central bank liquidity, and seeking some particular market product to which they could transfer their concerns and fears, ETFs quickly emerged as the current generations’ “CDO” – the product that will accelerate the next crash when the BTFD mentality that has defined the market for the past 8 years, finally ends as central bankers pull the rug from under an entire generation of traders.
Two months ago, Arik Ahitov and Dennis Bryan, who run the $789 million FPA Capital fund, took the subconscious fears about ETFs to the next level, when in taking a page out of the Warren Buffett warning books, the duo said that Exchange-traded funds are ‘weapons of mass destruction’ that have distorted stock prices and created the potential for a market selloff.
In an April letter the two warned that “when the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now.” They also noted a previously voiced warning that that “the flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals” and that “as the market moves ever higher, there’s the potential for a sharp decline.”
‘This new market structure hasn’t been tested,’ Bryan said, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. ‘We could get an onslaught of selling.’
The simplest summary of the latent worries about ETFs is that i) they provide phantom liquidity: there when not needed and gone when needed, and ii) as a result of wholesale capital flows, they misprice risk among bulk asset classes, so when selloffs occur, the most liquid underlying stocks – usually the most attractive ones – are hit the most.
This post was published at Zero Hedge on Jul 5, 2017.