One of the biggest trends in finance over the last two decades has been the shift from picking stocks to just hugging the index trillions
Of dollars have fled mutual funds and flooded into ETS investors. Just love low-cost diversification
But in a world full of ETFs, are they ignoring the risk?
That’s what we’re gonna talk about on this week’s episode of the one thing
What’s going on investors 8k here out of every dollar invested in America 50 Cent’s is held in a passive fun
according to Morningstar this summer
Passively managed assets have caught up to actively manage assets for the first time ever as a huge change to the way financial markets work
And a lot of smart people are saying that we’re not paying attention to the risks. They go along with that shit
Here’s portfolio manager Hari Krishnan with his view. I don’t like ETFs Andy TMS. Well there you have it. I’ll talk to you next week
No, I’m kidding. There’s more to this story. Here’s Hardy again ETFs are kind of chameleons
Especially bond ETFs. The reference basket is a set of bonds
But they’d trade like shares so people can easily get confused and I’m no no
I’ve been a victim to this to looking at the realized vol of something like the hyg, which has historically been about 3%
at least since the recent bull market and saying oh
This is a stock effectively that spits out a high dividend and that can be traded in and out
Intraday with a refreshed quote every 15 seconds or so and so all sorts of strategies that you wouldn’t think would be possible
In the bond market are now suddenly possible
Trading the hyg
This is a mistake and the reason it’s a mistake and I want to pound home this point
That realized vol is not a true barometer of risk
So the markets love it because it gives people a way to invest that was previously unavailable to Moe hyg
The high-yield corporate bond ETF is a great example of it back in the 70s
Retail investors had no chance investing in a diversified basket of junk bonds. So that’s the bright side
but what Hari means by chameleons is that when it comes to ETF things aren’t always what they see on a daily or even
Annual basis hyg
Basically does what it says it rises and falls based on corporate bond yields
and that’s pretty impressive because those bonds can be really hard to find the trade but in a really bad market environment this feature could
Begin to look like above so let’s say someone or a group of people try to sell a bunch of that ETF all at once
Well that sudden liquidity mismatch could cause prices to fall much faster than holders would expect I feel there are lots of hidden dangers
I’m worried about the embedded arbitrage mechanism in
ETFs the illusion that ETFs trade like shares when even when their reference basket is bonds and
If you put that toxic mix together
You can follow through a sequence which would lead to a fairly significant series of cascading sales
which would be a
8 to 10 standard deviation move not that that’s meaningful in the high-yield bond markets that could happen very quickly
So well, it happens tomorrow. I don’t know but what I’m focused on is random shocks of normal size
leading to sequences of sell-offs that can be
incrementally tracked
As they go through the system. So let me give you an example. Let’s say that one day
I promise to cook you a lasagne. Well on Tuesday you wake up hungry and you want your lasagne right now?
The problem is is that I never thought you would want lasagna for breakfast. So now I’m slapping together
Whatever ingredients I have in my cupboard and the lasagna you’re looking forward to looks more like a half-baked macaroni casserole or something
So the same way a huge drop in the price of hyg could cause a hunt for the underlying
assets
which are
inherently hard to find and as a result the decline in the share price could cause a huge decrease in the ETF’s value in a
Recent interview venture capitalist Josh wolf touched on this liquidity illusion
You have the illusion of liquidity because you have daily trading and and and ETFs and you know, they’re marked on a daily basis
But the underlyings suddenly might be a liquid and so I think that there’s a real risk of permanent
Impairment which is the true measure of risk of principal
So if that happens and retirees start saying wait a second, you know what let me go to cash
Let me get out of these bond funds that I thought was safe. You know that creates a problem
Well, they also might need to sell out of equity funds now in both asset classes
You’ve had a shift from passive from active to passive
so I actually think it’s a great time probably for active managers who can actually do security selection and
Determine because the simple algorithm for all of these things was dollar in buy and now it’s gonna be dollar out sell
Which means some of the good stuff is gonna be sold indiscriminately. So people are pushed out on the yield curve
they’re taking more and more illiquidity risk and they don’t realize it some people say that this
Dynamic will eventually lead to money flowing back into active funds, especially when the market cycle gets tougher check out
What Anthony scary Moochie has to say about it?
Oh
it’s solely understandable that things flooded in that direction because your interest rate policy and quantitative easing and everyone flooded into
ETFs and passive investing and so people were going for growth those stocks were exhibiting growth even though that they’ve got high
multiples Tabuk and high
Earnings per share in some cases some of those companies don’t make any money like a Tesla all of those things are problematic
but you levitated all those things and then you got the
Self-fulfilling prophecy wheel where okay, they’re going up. Let’s put more money in they go up more money in them
And so what you really have to worry about is yet that we didn’t press row seat on this. Yeah
Well, that’s why I’m instructure credit
That’s why I’m sitting heavily in structured credit because when it goes when this thing blows and if it doesn’t ever blow, that’s okay
Too because society is becoming wealthier and wealthier and skybirds will do well
But my job as skybridge is to protect people’s capital and to grow it nicely
Not to bet the farm for those people and so what will end up happening is when it does blow
You’ll have a great unwinding so the money will move. So let’s just say
You’re gonna break some of these ETFs, right?
ETFs are not sustainable if there’s a huge market per year
So in the event of a liquidity crisis ETFs could break and then you got those trillions of dollars that move from active to passive
They’re all at risk, but it’s worth noting. The scare. Moochie is in the fund of funds business
So, of course, he’s hoping that active investing will pick up again
So you might want to take that warning with a pinch of salt just like that lasagna
But considering the risk of a recession out there
you might want to take some time to figure out how your
ETFs and ETN actually work if you want to learn more about this battle between passive and active
Investing to make sure you subscribe to real vision. I’ll talk to you next week