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trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-05 08:07
Hey people, just read this piece on Bloomberg today. Have thought about this in a similar way myself and would like to get your opinions on it.

https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos?srnd=premium-europe

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

ronin


Total Posts: 506
Joined: May 2006
 
Posted: 2019-09-05 14:35
Meh.

So what does it boil down to? When there is a crash, etf issuers will have a hard time disposing of replicating stocks? As they sell, they will push stocks below fair value? And it will be worse for illiquid stocks?

Be still my beating heart. Never woulda thunk.

What is funny is that physical etfs will suffer from this liquid/illiquid rotation more than synthetics. Physicals actually do sit on these microshares and they will have to sell them, but synthetics mostly just hedge with a few principal components.

"There is a SIX am?" -- Arthur

trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-05 15:40
I am not at all familiar with how index funds are structured. From your response I conclude there are in fact index funds that track given index simply as "derivatives" (for lack of better word) without owning any underlying shares.

If that is the case, I guess some index funds simultaneously track the index and "are" it. Considering that all funds (derivatives and physical) track the index, why would it be worse for the physical etfs? I understand that they will have a hard time selling their assets, and that that would push the index further down, but since the derivatives track that same index anyways, they should follow too right?

A follow-up on that. I always hear about the great inflows into index funds currently, and I have been wondering why this does not seem to be fully reflected in company valuations(my own impression, no research on the topic so I might very well be completely wrong). But the reason for that would simply bet that some index funds are not actually owning the underlying?

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

gaj


Total Posts: 53
Joined: Apr 2018
 
Posted: 2019-09-05 17:49
Most of the biggest index funds do own the underlying stocks. Some funds hold a small amount of futures, but there are traders arbing futures against the underlying stocks, so effectively someone would still be buying the stocks. Some funds are structured as notes or swaps. Even for these, the issuers or market makers would still have to hedge by buying the stocks.

In fact the guy in the article seems to say the opposite of what ronin said -- illiquid/small cap stocks are safer because they are under-represented in index funds.

trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-05 22:19
Yes that was actually my understanding in the first place re:illiquid stocks being safer due to not being in index funds

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

tradeking


Total Posts: 25
Joined: May 2016
 
Posted: 2019-09-06 01:17
The crisis he is speaking of in the article would be a liquidity-driven one, not fundamental-driven. So what would happen is that everyone runs for the exits and bid liquidity goes to 0 and the stocks crash 10-20%, and then bounce right back up when the panic ends. It would not have a big impact for long term holders, but should be a bonanza for anyone providing liquidity (HFT, stat arb). This is in contrast with a real fundamental move which would cause stocks to crash to the floor and then stay there.

EspressoLover


Total Posts: 384
Joined: Jan 2015
 
Posted: 2019-09-06 01:44
To be honest, I don't think the concern Burry raises can be dismissed out of hand.

The danger zone is specifically on the small illiquid stocks that are in the index. Whereas the stocks that are too small/illiquid to make the index cutoff should be fine.

So for example the 400th biggest stock in the US is in a much worse position than the 600th largest. The former is still big enough to be in the S&P 500. In a hypothetical unwind scenario, it's gonna get slammed because it's liquidity is tiny compared to the massive tsunami of capital in index funds. That's not a concern for the 600th largest stock. Even though it's illiquid, it's not part of the S&P 500, so doesn't get directly affected by the unwind.

Just some back of the envelope math... SPY/IVV/VOO alone represent $500 billion in assets. Take a sleepy mid-cap name like DHR. It's 0.36% of the index. So, just the aforementioned ETFs are collectively holding nearly $2 billion in DHR stock. What happens if there's a sudden unwind event or flight-to-quality out of ETFs? The ADV on DHR is only about $225 million.

So if 25% of ETF head for the exit, you're talking about effectively liquidating 200% of the ADV in what? A day, a week, an hour, ten minutes? As far as I'm aware the APs can create/redeem shares continuously in real-time. But even if not market makers can go naked short for intraday positions. And ETF investors have become quite comfortable relying on what presumably looks like massive, cheap, reliable, continuous liquidity.

In my opinion it's mostly an empirical question. How many constituents have serious disconnects between their index weight and their liquidity? How "flighty" are the major segments of ETF investors? And how fast are their stop-losses/margin-calls/capital requirements likely to be triggered? How much stat-arb capital is available to absorb single-name dislocations?

I don't know what the answer to these questions are. And my gut sense is that it probably isn't crack the top 10 in terms of market risks to lose sleep over. In particular many (most?) ETF investors are individuals in long-term retirement accounts. That capital base is pretty much as stable as you can get. But I can see a potential channel, where if the stars align it might be a major problem. At the very least, it's an interesting question that probably deserves a closer look.

Good questions outrank easy answers. -Paul Samuelson

gaj


Total Posts: 53
Joined: Apr 2018
 
Posted: 2019-09-06 02:40
In my experience, most APs/MMs don't hedge with the perfect S&P 500 basket. They would usually start with the most liquid stocks and slowly try to converge to the basket. This means that when investors start liquidating the ETFs, not all stocks would be immediately sold in the exact proportions. The chain of events would be like this:

- Investor starts selling SPY/IVV/VOO
- MM gets hit on the bid and hedge by selling stocks
- MM sell the most liquid stocks first (the large caps)
- MM redeems the ETF to the issuer and hedges by buying the full S&P 500 baskets
- MM is now short large caps and long small caps

The MMs effectively provide a cushion for the small caps. They still have to unwind the long/short position at some point, but they can be more patient about it.

Maggette


Total Posts: 1161
Joined: Jun 2007
 
Posted: 2019-09-06 09:03
I would like to proxy hijack the thread and ask ES for his top 10 list of market risks:)

Since these days only a small percentage (about 15%-20%) of my day job is linked to a market (and a very obscure de-linked in european electricity and energy market), my only exposure to markets is an over engineered ETF portfolio in my PA. So possible fuck ups in indices and their ETF replication do concern me.

Ich kam hierher und sah dich und deine Leute lächeln, und sagte mir: Maggette, scheiss auf den small talk, lass lieber deine Fäuste sprechen...

ronin


Total Posts: 506
Joined: May 2006
 
Posted: 2019-09-06 13:08
So to clarify my point.

The common wisdom is that physical etfs are safer because, if the issuer goes bust, the worst that can happen is the investors take posession of the replication basket.

The liquidity bottleneck is the opposite. The rapid sell-off hits those who are sitting on the (relatively) illiquid symbols that are hard to shift. And that is primarily managers of physical etfs.

I am only talking about relatively illiquid index components - not illiquid stocks in general.

Futures and synthetic etfs are hedged, as @gaj says, using a handful of principal components which for spx rarely go beyond the top 100-200 stocks. So the liquidity bottleneck applies to a much lesser extent.

Which isn't to say the risk isn't there. The flash crash was a sell-off of index futures which cascaded into bid books of less liquid symbols being wiped clean.

But nothing about this is particularly new or noteworthy. If this is some new revelation, then you are probably not ready to trade - especially not other peoples money.


"There is a SIX am?" -- Arthur

trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-07 09:54
@ronin I am trading neither my own nor other people's money - but I would like to some day. That's why I am trying to learn by asking questions here.

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

Strange


Total Posts: 1591
Joined: Jun 2004
 
Posted: 2019-09-07 13:10
One can come up with a number of armageddonish contagion scenarios - I am not exactly sure what's the version that Bury is talking about.

Personally, I think the danger is in extreme correlation (in both directions) and in decrease in the number the value players due to lack of non-passive AUM. How exactly these dangers will play out is debatable.

"In Russia, every CDS ends in bullet payment"

ronin


Total Posts: 506
Joined: May 2006
 
Posted: 2019-09-09 10:45
> @ronin I am trading neither my own nor other people's money - but I would like to some day. That's why I am trying to learn by asking questions here.

@trialanderror,

My apologies if this sounded like a personal dig - it wasn't meant to be.

"There is a SIX am?" -- Arthur

trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-10 11:44
@ronin I kind of felt like it was so thanks for the clarification :)

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

ronin


Total Posts: 506
Joined: May 2006
 
Posted: 2019-09-10 12:37
> @ronin I kind of felt like it was so thanks for the clarification :)

OK I mean it actually kind of was - but it was directed at Michael Burry, not you...

"There is a SIX am?" -- Arthur

trialanderror


Total Posts: 34
Joined: Feb 2019
 
Posted: 2019-09-10 17:02
@ronin Aha I understand

Nous promettons selon nos espérances, et nous tenons selon nos craintes.

Kitno


Total Posts: 402
Joined: Mar 2005
 
Posted: 2019-09-10 22:14
Which crash hasn't been due to the fallacy of liquidity? What do I mean by this: the buy-in of the market that trade du jour is not a crowded trade and I can get out when I want - is this not just the bullshit of every bubble? Most people understand the underlying but they explain it away. As for credit ETFs this is the purest apogee of the last 100y: BS fallacy egged on/forced by crap regulation.

The Trusts of 1929
Mispriced options of 1987
Depth of bid in 1997/1998
Assurance of the CDO product 2007/2008
ETFs 202X

"Yeh, after that blow out I bid the bonds at 76 and you hit man...You're 77/81 now? Cool man...What? Do I care at 80? No mate... I'm 73 bid now...I'm sure you didn't just load up just for me...".
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