The Decade’s Biggest Investing Trend Will Destroy Your Portfolio
Here’s How This Popular Investing Vehicle Will Trigger the Next Market Crash – And How You Will Survive
ETFs are hot right now. So is passive investing.
Exchange-traded funds (ETFs) are all about relationships, so the marriage of ETFs and passive investing looks perfectly fine on the surface. But frighteningly, the basis of their relationship and the reason they look like they pair well will actually be their downfall.
In fact, friction between the two is so huge, a divorce could crash markets irreparably. It’s not a matter of if, it’s a matter of when. And it has ETF sponsors and regulators worried to death.
Here is the dirty secret behind ETFs, how passive investors will use them to crash the market, and how you can survive unscathed…
ETFs and Passive Investors at a Glance
Don’t get me wrong, ETFs are great. They’re packaged investment products that trade all day like stocks.
You can buy, sell and short ETFs that track:
- all the major stock market indexes
- any and every industry group
- different investing styles
- commodities like oil, gas, gold and silver
- entire countries
Just about any asset class or portfolio product Wall Street thinks you want to trade or leverage your bets with – even inverse ETFs that go up when their underlying market indexes go down. They are all here.
The first ETF in the U.S. was the SPDR S&P 500 ETF (NYSEArca:SPY). It was launched in 1993 by State Street Global Advisors under the product label Standard & Poor’s Depository Receipts (SPDRs).
Today, eighty ETF sponsors manage ETF fund families with almost $2.5 trillion in assets under management (AUM)… But just three companies sponsor the vast majority of these funds.
BlackRock’s ETF iShares products account for 39% of the market with AUM of over $1 trillion, the Vanguard Group has 23% of the market with $615 billion in AUM, and State Street Global Advisors has a 19% share of the market with $510 billion in assets under management. State Street has their SPDR products, of which $235 billion is in one ETF, the original SPY.
Together the “Big Three” control 82% of the ETF industry.
And now everyone’s trading ETFs, causing the market to grow explosively from 2002 through 2014.
Since 2009, trading volume in listed ETFs averaged 28% of the total consolidated dollar value of shares traded in the U.S. According to Keefe Bruyette & Woods’ ETF Spotlight Industry Update from February 3, the dollar volume in 2016 was 29% of all shares… worth $91 billion per day.
Of the 25 largest ETFs (by AUM), 58% of trading volume is accounted for by institutions with retail investors trading the remaining 42%.
|The Top 10 Most Traded Stocks by Dollar Volume (2016)
10) Bank of America Corp. (NYSE:BAC) traded $423 billion in shares
9) Microsoft Corp. (NasdaqGS:MSFT) traded $429 billion in shares
8) VanEck Vectors Gold Miners ETF (NYSEArca:GDX) traded $470 billion in shares
7) iShares MSCI Emerging Markets ETF (NYSEArca:EEM) traded $603 billion in shares
6) Amazon.com Inc. (NasdaqGS:AMZN) traded $710 billion in shares
5) Facebook Inc. (NasdaqGS:FB) traded $739 billion in shares
4) PowerShares QQQ Trust ETF (NasdaqGM:QQQ) traded $784 billion in shares
3) PowerShares Russell 2000 ETF (NYSEArca:IWM) traded $931 billion in shares
2) Apple Inc. (NasdaqGS:AAPL) traded $1.008 trillion in shares
1) SPDR S&P 500 ETF Trust (NYSEArca:SPY) traded $5.480 trillion
To give you an idea of the scale, I have to the right the top ten most traded stocks by dollar volume in all of 2016 in reverse order. Do you see those five ETF’s in there? Did you notice that SPY traded 5 times more than Apple?
ETFs are the golden child of the passive investing strategy, which is the opposite of actively managing a portfolio.
Active management can incorporate timing investments, taking profits, rebalancing, holding various amounts of cash, and sometimes shorting stocks or asset classes. In contrast, passive investing is all about not trying to beat the markets, but following them closely, since they tend to go up over time.
What happened in 2008, and how markets and managers performed since 2009, tells the story of the modern rise of passive investing.
If you remember, stocks fell about 50% in the credit crisis of 2008. Everyone got clobbered. Mutual fund investors, actively managed portfolios, passive investors, and just about everyone else lost big time. Only a tiny handful of swashbuckling hedge fund managers shorted subprime mortgages, banks, and the market and hit the jackpot.
A lot of investors lost faith in their managers, their mutual funds, and the market. They got out on the way down or at the bottom in early 2009.
No one knew that March 2009 would be the start of the market’s comeback to incredible new highs.
At their recent all-time highs, the Dow Jones Industrial Average is up 229% since March 2009, the S&P 500 is up 255%, and the NASDAQ is up an astounding 360%.
A passive investor who theoretically got into the market at its lows, or held onto their stocks since hitting their lows in 2009, would have reaped these big rewards. No active manager anywhere in the world has come close to the passive gains investors could have reeled in since 2009.
With the market’s recent history and the likes of Warren Buffett and Vanguard advising investors they can’t beat the market or that active managers’ fees are a huge additional headwind on performance, it’s no wonder passive investing has become all the rage.
Not only are investors going passive on their own by constructing portfolios with index and benchmark ETFs and mutual funds, brokerages are pushing so-called “robo-advisory” services on investors. These investors, who want somewhat actively managed (insofar as rebalancing lopsided portfolios from gains or losses) investment accounts, are getting algorithms that gently rebalance passive holdings to attempt to maintain the account holder’s investing objectives.
In theory, it all makes perfect sense.
The marriage of exponentially growing ETFs and the fast-growing passive investing trend are enticing more and more investors who’ve been out of the market for years back onto the playing field, as they tiptoe back in as news channels regularly report higher all-time highs.
But what makes sense on the surface, is in reality an already overgrown killing field drawing in the unsuspecting and uninformed.
ETFs’ Dark Secret That Will Bring Down the Markets
I’m going to use a scary word to describe ETFs, although you won’t hear the word used when it comes to ETFs anywhere else. That’s because not many people understand that the word absolutely applies.
The people who know it’s the truth – the sponsors of ETFs, brokers, and regulators – don’t want you to ever think of “that” word when you think about ETFs.
ETFs are derivatives.
There, I’ve said it. Now you know.
An ETF doesn’t exist on its own. Every ETF is derived from other financial instruments or multiple instruments, or derivatives of financial instruments.
For example, take the SPDR S&P 500 ETF (AMEX:SPY); the biggest, most liquid, and most traded ETF in the world. The SPY ETF is derived from all 500 stocks that make up the S&P 500 index.
The prices of those 500 stocks are capitalization weighted, and it represents what it would cost an investor to “own the market” if they were to buy one share of each of the 500 stocks in the S&P 500 index.
Source: Index Funds Advisors, Inc.
It’s important to understand that SPY (and every other ETF) is a derivative of what securities underlie it.
And that’s where the trouble lies.
ETF shares are created from underlying securities when an ETF sponsor (the companies that own ETF families) engages an “authorized participant” (AP) to buy the right amount of underlying securities to accurately represent what the ETF is supposed to track. The AP – who can be a market-maker, a specialist, a broker-dealer, or a big financial institution – buys up the underlying securities and delivers them to the sponsor. The sponsor gives the AP an equal amount of “creation units”, AKA ETF shares. The AP then sells those units, or shares, to buyers in the open market. That’s how ETF shares come to market.
There isn’t a problem with creating more units if demand for the ETF shares is robust. If the stock market is rising and more and more investors want to buy ETF shares to join in the rally, the sponsor will have the AP buy up more underlying shares (which itself can raise prices) and turn them over to the sponsor for creation units to sell in the open market to eager buyers.
But what happens when there are more sellers than buyers? What happens to ETFs then?
What happens can be catastrophic. Especially as more and more so-called passive investing strategies call for more and more indexed ETFs to be stuffed into passive investing accounts.
Let’s say there’s a big selloff and ETF investors start selling lots of their shares. If there are no buyers for those shares, the balance between all the underlying stocks APs bought and the number of creation units that were made to equal those get out of balance. APs then have to sell the underlying stocks (or whatever underlies the ETFs being sold) so the shares of ETFs being sold by investors can be destroyed.
Thus creates a huge negative feedback loop.
As authorized participants sell underlying shares, they are driving down those share prices. As the value of the indexes that represent those underlying shares fall, due to the heavy selling of the underlying shares, the share prices of the ETFs fall causing panicked investors to sell them. That’s when we have our negative feedback loop that can crash stocks as selling begets selling which begets selling.
All of a sudden passive investing looks like a trap.
But it gets worse.
Authorized participants are market players themselves. If they see markets falling and know they have to sell shares of underlying stocks in ETFs that are falling, they can short both the ETF shares and underlying shares of whatever the ETFs are made of to make money from falling prices.
Let me break this down. The same market-makers, specialists, and financial institutions that make money buying shares to deliver to sponsors to get creation units can force down the price of those units by shorting them and underlying shares to knock down ETF prices, to get ETF holders to sell them, to knock down prices, to make a profit when prices fall. If there’s money to be made from shorting stocks, of course the pros will try and make money doing that.
What sponsors and regulators don’t want you to know is that authorized participants have absolutely no obligation to buy the ETFs being sold in the market.
That’s right. As panicked passive investors become active sellers, APs knocking down ETF prices don’t have to buy them. They’re not buyers of last resort. If they don’t step in and buy ETF shares, of course prices can keep going down.
It’s not something passive investors buying ETFs ever think about. But they should.
We caught a glimpse of it happening in the May 2010 flash crash, in the ugly opening of the markets on August 24, 2015, and when the same thing happened to high yield ETFs in December 2015.
Those were selloffs that got “corrected” because they were contained. But we all saw what can happen and how selling ETFs and the stocks and securities that underlie ETFs affect markets on the way down.
The biggest and most important ETFs are market benchmark indexed funds. That means they are market proxies, and that’s why passive investors park money in them.
Essentially, they are the market. And, if the market’s selling off, they will be falling in price while…
- The underlying stocks they hold will be going down in price.
- The ETFs themselves will be going down because investors will be selling them
- And professionals and the authorized participants who work them up and down will be shorting them and the stocks underlying them.
Now you’re starting to get it. All that selling will cascade upon itself creating a negative feedback loop that could potentially devastate stocks.
There’s a big, ugly selloff coming. Passive investors selling their ETFs could start it, or they could make any general selloff a full-fledged crash by dumping their ETFs on the way down.
It’s not a matter of time, it’s a matter of when.
How to Hold On to Your Profits and Get Out Unscathed
No one knows when the next big market selloff is coming.
If we did, we’d already be protecting ourselves by selling positions and shorting the market to make a ton of money on the fallout.
For the rapidly-growing passive investing crowd, the new crusaders and millions of former mutual fund investors who think there’s a new foolproof way to invest, the fact that markets go down may not be so worrisome. That’s because they think passive investing is some kind of miracle investing scheme that always makes money because fallen markets will rise again and, lately, seem to continue making new higher highs.
Mutual fund investors were lured into parking trillions of dollars in fund families based on essentially the same premise. They now know better.
When the next market selloff comes – and it’s coming – passive investors are going to get hit hard with the reality of markets.
The pain investors feel when they see their life savings dwindling before their eyes hasn’t changed.
Passive investors will become active sellers, especially if the initial selloff is unexpected (which it has to be at this point in the up-cycle), steep, and front page news… Not just in the financial press.
That’s when the marriage of ETFs and passive investing strategies will start to burn the masses.
When the ETF shares start being sold, it forces authorized participants to sell underlying shares. But they’ll also short the underlying and ETF shares to both hedge themselves and, more importantly, to make a ton of money pushing markets down hard and fast. That will shake passive investors to the core and beget more ETF selling.
Here’s how to protect yourself.
Since it’s impossible to time the moment when a selloff is going to turn into a full-fledged rout, panic, or outright crash, my number one rule for protecting any money exposed to market swings is to take profits.
As I always say, you never get hurt ringing the register. Never.
I use trailing stops. They are stop-loss orders that I keep raising as the stocks I own go up in price. Generally, I like having my stops about 10% below where my stocks are trading. As they rise in price, I adjust my stop-loss orders higher, to prevent from giving back too much of my profit. Whether you use a 10%, 15%, or 5% stop-loss order from where your stocks are, it should be a function of how volatile they are on a daily, weekly, and monthly basis. The more volatile your stocks are, the more room you need to give them to move around.
Stop-loss orders that trigger and take you out of positions with profits are great. You ring the register and you have to look at that stock again to see if you want to get back in, or find another position to ride. Stops getting triggered forces you to look at the market, the whole market, and see if the market is slipping and causing your stocks to trigger their stop-loss orders.
Being out of the market, if the crash comes, is a gift you’ll never forget. Use trailing stops.
Watching the market is key to getting out of the way of a barrage of ETF selling, of passive investors becoming active sellers, and of you getting your head handed to you.
If you see that happening, even if you think you see that about to happen, you should probably just sell your ETFs. You can always buy them back.
However, after a panic selloff has begun and with the way the markets are these days, putting down stop orders could get you out a lot lower, a long way below where you put your stops down.
That’s why it may be a good idea to just sell at the market as soon as you want to get out.
If you use stop orders, even if you’re using trailing stop-loss orders to protect profits, there’s no guarantee you’ll get out at your stop-loss price (or even close). We’re all limited by the new market realities and having stops get hit a lot lower than you would like is a reality.
Again, that’s why it’s better to be proactive and take profits when you can, hopefully before a big selloff.
Another thing to know about keeping stop-loss orders regularly, as opposed to putting them down just when prices start to fall or using market sell orders once a panic has begun, is that you may have a case to ask for better fills if you had stop-loss orders down for a while. That’s just because brokerages may have a way to resolve some ugly fills in your favor. There’s no guarantee they will be able to do that, but you’ll have a better chance of them trying to improve your fills if you had orders down as opposed to trying a hard selloff.
Hopefully, you’ll get out of harm’s way before the big waves of ETF selling and shorting that leads to more selling and shorting tanks markets.
If you’re quick enough, and you should always have a plan to do this in your back pocket, you can make a ton of money off the ETFs passive investors sell. Massive profits can come from buying put options on leveraged market ETFs that go up twice as fast as their underlying indexes, because when they go down they will go down twice as fast as the markets do.
By buying puts on leveraged long ETFs you don’t have to worry about any bounce or getting caught being short.
Just remember that markets can bounce back at any time, so if you buy put options and make a killing on a panic selloff, don’t get greedy. A few hundred percent gain is a nice payday. Take it, or take half of your put options off and use a stop to sell the rest if markets bounce higher.
Though marriage of ETFs and passive investing looks good, like most marriages starting out, be prepared for trouble. Some marriages are bound to blow up.