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Crisis in the stock market

Will ETFs cause the next stock market crash?

Paul Rickard
19 September 2019

Michael Burry, the hero of The Big Short movie, has joined the growing chorus of commentators warning about risks to the financial system due to the huge inflows into index tracking, passively managed exchange traded funds (ETFs). In fact Burry, who made a fortune correctly betting against CDOs (collateralised debt obligations) before the onset of the GFC, has gone one step further and described the inflows as a “bubble” and “like most bubbles, the longer it goes on, the worse the crash will be”.

So could ETFs cause the next stock market crash? 

I think it is very unlikely but before coming back to this and actions investors can take to mitigate this risk, let’s take a closer look at his arguments.

Burry’s thesis

Globally, there is more than US$5 trillion invested in passive, index tracking ETFs. In the US, where you can access an ETF for almost any market/sector/industry/investment thematic, equity assets being managed passively (that is, on ‘auto-pilot’ to blindly track an index) is almost the same as the value of funds being managed actively. As the following chart shows, the gap has closed remarkably over the last decade.

US Equity Fund Assets – Active (blue) vs Passive (orange)

Source: CNBC and Morningstar

Burry contends that passive investing is removing price discovery and that assets aren’t being accurately priced for risk. Because ETFs just buy securities because they are part of an  index, rather than because they are cheap or good value, this can lead to overpriced securities. Further, securities that make it into an index get an artificial boost compared to those that miss out.

This is diminishing the primary role of the marketplace, which is to establish a price for a security based on the analysis conducted by buyers and sellers. If it is just the weight of inflows or outflows that drives a stock’s price, no consideration is being given to the risk of that investment.

On a more practical level, Burry is worried about liquidity risk when it comes to ETFs exiting positions. He cites the example of the world’s most tracked index, the US S&P 500, which consists of the 500 largest US companies. But according to Burry, 266 stocks (over half) have daily trading volumes under U$150m in total. So despite there being hundreds of billions of dollars in ETFs tracking the S&P 500, the underlying liquidity of many of the component stocks is relatively poor. So if investors decided to exit the market and liquidate their ETFs, and the ETFs in turn need to liquidate their underlying holdings, there isn’t the liquidity available to make this possible. A rush to the door could trigger a very messy outcome.

He also notes that there are many derivative contracts linked to ETFs, plus buy/sell strategies used by the funds to pseudo-match flows every day. These make the situation potentially worse – it “won’t end well” according to Burry.

There are also some unusual players in the ETF game. For example, the Japanese central bank (the Bank of Japan) has amassed over the last decade, such large holdings that it now owns close to 80% of Japanese equity ETFs. This has been one of the key drivers for a huge mismatch between the valuation of large cap Japanese stocks and small cap stocks (Burry says “extreme undervaluation” in the case of some small caps). He also suggests that in a global market panic, the Japanese central bank could be a stabilizing force that leads to large cap Japanese stocks being relatively protected compared to their peers in the US, Europe and other parts of Asia.

Burry’s critics note that he is an active fund manager, the founder of Scion Asset Management, a private investment firm focussed on small cap stocks.

Should you worry?

I don’t think ETFs will cause the next crash. Firstly, stock market crashes are typically caused by external forces, such as rising inflation and interest rates in 1987; rising interest rates again for the bursting of the dot-com bubble in 2000; and the failure of debt rating agencies to assess the risk of CDOs that led to the credit crunch induced crash of 2007. Secondly, there is in effect an automatic “stabilizer” that will slow an ETF stampede  – a widening spread between bid and offer.

One of the more attractive features of ETFs is that there are market makers (investment banks) who compete by making a bid/offer spread to deal. This allows investors to enter the market and pay a price for the ETF which is very close to its underlying NTA (net tangible asset value), or exit an ETF holding at a price which is also very close to the NTA. The market makers build long or short positions, and have access to the ETF issuers to access new units or redeem units they own at the underlying NTA.

This works well in good market conditions, leading to fine bid/offer spreads (sometimes only a few basis points). But in a significant downward  move, unless the market makers have  very deep pockets, the most likely response is for the market makers to widen their spread, probably very materially. Ironically, wider spreads means that it becomes less attractive for investors to sell their ETFs, and if they are wide enough, the selling dwindles to a trickle.

A serious market correction could have a bigger impact on small cap stocks than large cap, as there will be some shrinkage in the size of ETFs (the market makers will be forced to redeem some units). Further, investors know that large cap/leading stocks recover in price  first, so they tend to steer away from small caps when the market is heading south.

If you do share Burry’s concerns and are worried about an ETF meltdown, here is how you can mitigate the risk. Importantly, focus on ETFs from the major issuers (the Vanguard’s, BlackRock’s etc). These guys have deep pockets and arguably, are in the “too big to fail” category. Next, look at ETFs that follow the major indices. Be wary of ETFs that are tracking peripheral indices (in the USA, for example, regional banks), non-standard indices or compiled indices. ETFs based on broad based indices with large caps may be more liquid than ETFs  focussed on small caps. Finally, avoid exotic or synthetic ETFs (not really a big issue in Australia). The latter are ETFs that invest in a derivative of a product, rather than the underlying product itself.

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