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How to Profit from the Explosive Divorce of ETFs and Passive Investing

0 | By Shah Gilani

The marriage of ETFs and passive investing, the current hot trend everyone’s talking about, isn’t a match made in heaven.

In fact, friction between the two is so huge, a divorce could crash markets irreparably.

On their own, both buying into ETFs and investing passively make sense. But loading up passive investing portfolios with ETFs – especially benchmark and market index following ETFs, which are precisely what passive investing calls for – is the equivalent of rubbing two sticks together over a mountain of dry kindling.

I’ve given you the numbers on how big ETFs have become and how hot passive investing is getting. And, to the chagrin of ETF sponsors and regulators, I’ve unpacked the truth for you about how ETFs are created and destroyed and how the market professionals with the inside track on trading ETF shares alongside the underlying securities they’re made from are self-serving.

Now, I’ll tell you what you need to do to protect your passive portfolio, your actively managed portfolio, and your you-know-what when the fire gets lit…

Keep Your Profits When You Have Them

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.

Turn This Negative Feedback Loop into a Hefty Payday

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…

  1. The underlying stocks they hold will be going down in price.
  2. The ETFs themselves will be going down because investors will be selling them
  3. 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.

If you see that happening, even if you think you see that about to happen, you should probably just sellĀ  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.

Sincerely,

Shah

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