#volatility

Explaining stock market volatility

They say a picture explains 1,000 points…

…the lighter side of market volatility which in reality is probably not far off the mark.

FNF Media wrote back in October 2015,

ETFs are hitting the market faster than the dim-sum trolley can circle the banquet hall. Charles Schwab, in the 12 months to July 2015, saw a 130-fold preference of ETF over mutual funds given their relative simplicity, cost and transparency….

…ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership as a percentage of total outstanding shares carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. As more bearish market activity has arrived since August 2015 we investigate how ETFs may impact given a large part of recent existence has been under more favourable conditions…

CEO Larry Fink of Blackrock, the world’s largest ETF creator, has made it clear that
leveraged ETFs (at present 1.2% of total ETF AUM) have the potential to “blow up the whole industry one day.” The argument is that the underlying assets that provide the leverage (which tend to have less liquidity) could cause losses very quickly in volatile markets. To put this in perspective we looked at the Direxion Daily Fin Bull 3x (FAS) 3x leverage of the Russell 1000 Financial Services Index. As illustrated in the following chart FAS in volatile markets tends to overshoot aggressively

…The point Mr Fink is driving at is more obvious in volatile markets, the average daily return is closer to 10x (in both directions) than the 3x it is seeking to offer. This is post any market meltdown. On a daily basis, the minimum and maximum has ended up being -1756x to 1483x of the index return, albeit those extremes driven by the law of small numbers of the return of the underlying index. Which suggests that in a nasty downturn the ETF performance of the leveraged plays could be well outside the expectations of the holders.”

FNF Media has said for many years, where CDOs and CDSs required the intelligence of a mythical hermit atop a mountain in the Himalayas to understand the complexities, ETFs are the complete opposite. Super easy to understand which inadvertently causes complacency. Unfortunately, as much as they might try to do as written on the tin, the reality could well turn out to be the exact opposite.

Forget the return “ON” your money. Just look to the return “OF” it

CM knew a lot of passive indices existed but not to this crazy extent. Probably explains why there is so much stupid money tied up in me too commoditised investment products. 4 years ago CM wrote a piece on the dangers of ETFs (especially leveraged)  and passive products in a downturn. These products predominantly follow the market, not lead it. So if these products end up stampeding toward the exits in a market meltdown, the extent will be amplified, especially those levered funds potentially making market panic look worse than it really might otherwise be. Don’t be surprised to see the mainstream media sensationalise the size of any falls in the market.

According to Bloomberg, 770,000 benchmark indexes were scrapped globally in 2019…however  2.96 million indexes remain around the world, according to a new report from the Index Industry Association…There are an estimated 630,000 stocks that trade globally, including c.2,800 stocks on the NYSE and c. 3,330 on NASDAQ or 5x as many indices as there are securities globally.

CM wrote back in October 2015,

ETFs are hitting the market faster than the dim-sum trolley can circle the banquet hall. Charles Schwab, in the 12 months to July 2015, saw a 130-fold preference of ETF over mutual funds given their relative simplicity, cost and transparency….

…ETFs, despite increasing levels of sophistication, have brought about higher levels of market volatility. Studies have shown that a one standard deviation move of S&P500 ETF ownership as a percentage of total outstanding shares carries 21% excess intraday volatility. Regulators are also realising that limit up/down rules are exacerbating risk pricing and are seeking to revise as early as October 2015. In less liquid markets excess volatility has proved to be 54% higher with ETFs than the actual underlying indices. As more bearish market activity has arrived since August 2015 we investigate how ETFs may impact given a large part of recent existence has been under more favourable conditions…

CEO Larry Fink of Blackrock, the world’s largest ETF creator, has made it clear that
leveraged ETFs (at present 1.2% of total ETF AUM) have the potential to “blow up the whole industry one day.” The argument is that the underlying assets that provide the leverage (which tend to have less liquidity) could cause losses very quickly in volatile markets. To put this in perspective we looked at the Direxion Daily Fin Bull 3x (FAS) 3x leverage of the Russell 1000 Financial Services Index. As illustrated in the following chart FAS in volatile markets tends to overshoot aggressively

…The point Mr Fink is driving at is more obvious with the following chart which shows in volatile markets, the average daily return is closer to 10x (in both directions) than the 3x it is seeking to offer. This is post any market meltdown. On a daily basis, the minimum and maximum has ended up being -1756x to 1483x of the index return, albeit those extremes driven by the law of small numbers of the return of the underlying index. Which suggests that in a nasty downturn the ETF performance of the leveraged plays could be well outside the expectations of the holders.”

CM has said for many years, where CDOs and CDSs required the intelligence of a mystical hermit atop a mountain in the Himalayas to understand the complexities, ETFs are the complete opposite. Super easy to understand which inadvertently causes complacency. Unfortunately, as much as they might try to do as written on the tin, the reality could well turn out to be the exact opposite.

Hence CM continues to believe that stocks with low levels of corporate social responsibility (CSR) scores like tobacco companies such s Philip Morris, JT and Imperial Tobacco, as well as gold/silver bullion,  look the places to be invested. Cash won’t necessarily be king because the banks are already in a world of pain that hasn’t even truly started yet. Aussie banks look like screaming shorts at these levels. The easiest way for the plebs – without access to a prime broker – to do this is to buy put options on individual bank names. Out of the money options are dirt cheap.

Banks

Forget the return ONyour money. Just look to the returnOFit.

NB, none of this constitutes investment advice. It is a reflection of where CM is invested only. 

 

A reminder on the extra market downside risk created by ETFs

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As a reminder in markets selling off in recent days, please find a report which touches on the extra volatility created by ETFs on the downside that amplifies market sell offs.

An excerpt of the report is as follows;

CEO Larry Fink of Blackrock, the world’s largest ETF creator, has made it clear that leveraged ETFs (at present 1.2% of total ETF AUM) have the potential to “blow up the whole industry one day.” The argument is that the underlying assets that provide the leverage (which tend to have less liquidity) could cause losses very quickly in volatile markets. To put this in perspective we looked at the Direxion Daily Fin Bull 3x (FAS) 3x leverage of the Russell 1000 Financial Services Index…The point Mr Fink is driving at is…the average daily return is closer to 10x (in both directions) than the 3x it is seeking to offer. This is post any market meltdown. On a daily basis the minimum and maximum has ended up being -1756x to 1483x of the index return, albeit those extremes driven by the law of small numbers of the return of the underlying index. Which suggests that in a nasty downturn the ETF performance of the leveraged plays could be well outside the expectations of the holders.

The “bigger” point about the FANG sell off

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While the press is waxing lyrical about the unprecedented loss caused by a sell off in FANGs (Facebook, Amazon, Netflix & Google) we should note that it overlooks one factor. Before getting to that, to start with the sell off in gross dollar terms it is unsurprising given the already highly inflated value of the base stocks. So if A $500bn market cap Facebook loses 4% it is equivalent to $20bn. On one day FB lost a Fiat Chrysler. It’s math. Let’s not forget that Bitcoin is now worth $165bn but let’s not let that bubble spoil the party.

The problem that faces financial markets is the advent of ETFs. While stupefyingly simple to understand as an investor it is that same simplicity that breeds complacency. ETFs are simple products that enable investors to pay much lower fund management fees to buy easy to understand baskets- whether coal, gold, oil or FANGs. There are 106 ETF products that own Facebook as a Top 15 holding with that averaging between 5% and 10% of the entire fund.

Yet on the way up things are rosy. It is what happens on the downside that has yet to be fully tested. Around two years ago, CM wrote a report which warned of the risk of ETFs on the downside, especially levered ETFs (i.e. you buy a 2x levered FANG fund which means if FANG stocks go up 5% you theoretically get 2x the return for any given move up or down.

However in times of uncertainty (i.e. heightened risk) the options markets that price risk move magnitudes on the downside vs the upside. Meaning for an ETF to replicate what it proclaims on the brochure becomes much more difficult meaning the fund may under or overshoot the promises. Also in certain markets (e.g. US & Japan) where stocks on the exchange have limit up/down rules on the physical stock, should a market crash ensue, the ETF prices on the theoretical values of stocks that may not have opened for trading. What that means is that the ETF may reflect a market that is 10-15% below where it actually eventually opens. Meaning poor ETF buyers get gouged. However the computer algorithms in the ETF end up chasing, not leading the market which in and of itself creates more panic selling further reducing market confidence. Where a market might have traditionally fallen  3% on a given piece of bad news, ETFs tend to react in ways that might cause a market to retreat 6%. Indeed market volatility is amplified by ETFs.

At the moment market behavior is exceedingly complacent about risk. Before GFC highly complex products like CDOs and CDSs were the rage. 99% had next to no clue how they operated but they found their way into the local government investment portfolios of even small country towns in Australia.

ETFs on the other hand are strikingly simple to grasp but that also means we pay far less attention to the risk that goes with them. That is the bigger worry. People complacently thinking their portfolios are safe as houses may wake up one morning wondering why some flash crash has caused Joe and Joanne Public’s retirement nest egg to get decimated.