The threat of concentrated ETF holdings in single name stocks is hardly new. Back in April 2017, One River CIO Eric Peters warned about the dangers lying in wait for capital markets in a world dominated by passive investing.
Each day since the election $1bln has moved from active to passive management. When you buy the S&P 500, you pay the prevailing price for every one of those stocks. 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. When these markets do finally have a correction there will be no bid for many of these stocks.
I don’t know when the next major crisis will hit, no one does. But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management. $500bln has shifted to index investments, distorting the way equities are valued and the historical relationship between short sellers and buyers. This flow creates artificial demand for poor-quality securities that have few natural buyers. And now even Warren Buffett is telling investors to shift to passive.
Shortly thereafter, Horseman Global's Russell Clark pitched a new bear thesis: go short all the names that have an disproportionately heavy ETF ownership. Citing the transition from active to passive as a catalyst that makes markets even more inefficient, Clark repeated a lament made by many short sellers, stating that there "are complaints from some quarters about it being harder to short sell as flows of money push up stocks."
But it was the downside that he was focused on:
The long bull market in passive investment has made them wilfully blind to the liquidity risk that they are running. Passive investments are concentrated in the US market...
Since then many more pundits joined the chorus of warnings against ETFs, and the danger their "blind flows" pose to stocks, if not on the upside then certainly on the way down. And yet, so far it has been largely so good, with only an occasional hiccup in what has otherwise been an increasingly ETF dominated marketplace.
So fast forward to today, when SocGen became the latest to ring the alarm bells on the perils associated with ETF investing and warn on the brewing liquidity risks... provoking a sharp rebuke from the world’s largest asset - and ETF - manager.
One week ago, SocGen analyst Sebastien Lemaire stress-tested the fragility of 16,000 stocks, and concluded that small caps, dividend shares and gold miners are all especially vulnerable in market drop as a result of outsized ownership among passive/ETF investors. In turn, those positions could prove more difficult, and certainly costly, to exit. Furthermore, given the BOJ's massive purchases - which now owns nearly 80% of all Japanese ETF holdings, the Nikkei 225 Index is also especially fragile to a reversal of the constant passive buying.
"Crowdedness exists but is limited to a few stocks and strategies," Lemaire warned, and while his warning wasn't nearly as dire as that of Warren Buffett or Howard Marks, both of whom have similarly cautioned about the liquidity shortage that ETFs have inspired, SocGen did caution that small caps would be whipsawed by this dynamic - since the same stocks in the sector make an appearance in multiple indexes tracked by ETFs, according to the report.
And, as Bloomberg noted, the conclusion provides more ammo for regulators and ETF detractors on Wall Street, who charge the post-crisis flood of passive money has led to an investing-herd mentality and even more crowding risk (something hedge funds felt acutely in July when Facebook tumbled).
That's probably also why the world's largest issuer of ETFs - BlackRock - felt compelled to respond, dismissing the warnings.
“This research is underpinned by two assumptions that don’t reflect the historic behavior of investors or ETFs,” the firm said in an emailed statement.
“To assume that all investors behave the same way in times of market stress is not grounded in reality. Additionally, we have repeatedly seen ETF volumes grow dramatically during times of stress as investors utilize them as a tool for price discovery.”
Actually, it is somewhat safe to say that as traditional, carbon-based traders have been replaced by algos and computers, most investors behave in precisely the same way. It also explains why for the past decade virtually every single dip has been collectively bought, as there is no longer any adverse response to behaving just as the herd has behaved on so many prior occasions.
Meanwhile, SocGen's theory is that a tumbling market, secondary liquidity in the ETF would likely evaporate, forcing traders to shift to the primary venue, with the liquidity of assets underlying the passive instrument subject to increased selling pressure. This is precisely what happened in August 2015 when ETFs traded with massive disconnects to the underlying during a marketwide cross-asset decoupling, allowing many quick traders to arb the divergence and make substantial profits.
Furthermore, as Bloomberg notes, "weighting dynamics also increase crowding risks in dividend equities, with a clutch of gauges boosting exposures to shares with modest market capitalizations given their high yields." That, in turn, has led to heavy holdings by ETFs of stocks like Tanger Factory Outlet Centers Inc. and Meredith Corp. Gold miners stocks are also at risk, due to their large ownership by the likes of VanEck. The ownership creep eventually led the VanEck Vectors Junior Gold Miners ETF, to change its index last year after ownership stakes in some companies rose above 10 percent.
It wasn't all bad news: according to the French bank, a whopping 90% of global equities are not subject to heightened risk of a liquidity squeeze because they’re owned 10% or less by ETFs.
Meanwhile, recent market volatility suggests that the "tipping point" for ETF risk has not yet been hit, after passive funds passed what Bloomberg calls the year's stress test:
BlackRock points to action in its iShares MSCI Turkey ETF, ticker TUR, last month when the country’s assets were roiled by increasing tensions with the U.S. The ETF’s underlying index plummeted 16 percent on Aug. 10, but trading in the fund remained orderly, with no discernible impact on the underlying shares.
“TUR saw its highest amount of daily trading volume ever, with 13.3 million shares exchanging hands that day, compared to its previous average daily volume of 500K shares,” according to the statement.
Which is good news for retail investors - the biggest users of ETFs - but the observation merely indicates that the pain threshold of ETFs has not yet been hit, the way it was in August 2015.
At the same time, regulators continue to warn of liquidity challenges spurred by the ETF revolution. The latest was the European Systemic Risk Board. In a report this month, it warned that market stress could "create first-mover advantages if, for instance, primary markets offer stale prices, while the underlying markets are turning illiquid."
The result? The report concluded that "Investors may expect there to be greater liquidity than that available during times of stress." We are confident that BlackRock would dispute that as well, and retail investors will be happy to believe it, at least until all the ETF liquidity warnings come are validated once again.