“Simplicity of ETFs” doesn’t always equate to more safety vs “Complexity of CDOs”

Remember how we were told how CDOs and synthetic CDOs were so mathematically complex that only a mythical hermit in the Himalayas could decode them?

Thank god we saw an explosion “as it says on the tin” exchange-traded-funds (ETFs) thrust upon us. So simple. Pick a basket of stocks, indices or commodities and one could get access to a whole range of products under that banner. One might feel that the S&P500 will go up so will look to buy a leveraged product of 2x or 3x to maximise returns. Even better the ETFs were far cheaper fees wise too.

Unfortunately, to hedge the risk of doubling exposure requires liquidity in the derivatives market. When markets panic and start sinking, the ability to keep the product true to its promises becomes quantum leaps harder. The explosion in the spreads on derivatives pricing (delta bleed) of the hedged products puts more downward pressure on the market.

Looking to ETF activity in the market, for the first week of March they comprised 34% of total activity up from 24% in February.

This is why ETF volatility on the downside is so much worse. By its design, an ETF ‘replicates’ the cash index it tracks. If the S&P500 falls by 2%, the S&P500 ETF product is designed to copy it. So it is always lagging, not leading.

Therefore if the market is having a coronavirus based sell-off, what might have been a 4% decline (big but not diabolical) turns into a 7% correction, especially when the leveraged products chime in. They might be small at 2% of the traded ETF market but the additional pressure starts to compound in the non-leveraged product too.

Because the media is so conditioned to compare apples with oranges with these recent declines to those we saw in 1987, 2000 or 2008, periods where relatively tiny levels of ETFs drove volatility, the cash market equity investors can get spooked by the optics of the sell-off which is merely the ETFs/levered ETFs playing catch up. So it can trigger more selling which exacerbates panic under, some might say, false pretences. It starts a chain reaction.

If you wish to learn more about the dynamics of ETF sell-offs please refer to the link here. The CEO of Blackrock, the world’s largest ETF provider infamously said,

leveraged ETFs have the potential to “blow up the whole industry one day.

We are starting to see the evidence emerge. The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility.

It is back toward 2008 highs. The spikes are effectively marking the “delta bleed”. This is why we need to keep an eye on the levels of activity in the ETF market potentially accelerating the extent of the market gyrations. Don’t be fooled into thinking ETFs are safe as houses products.

VIX

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