Exchange-traded funds (ETFs) are all about relationships, so the marriage of ETFs and passive investing looks perfectly fine on the surface. But frighteningly, the basis of their relationship and the reason they look like they pair well will actually be their downfall.
There’s the one thing you need to know about ETFs that you probably have no idea about.
I’m going to use a scary word to describe ETFs, although you won’t hear the word used when it comes to ETFs anywhere else. That’s because not many people understand that the word absolutely applies.
The people who know it’s the truth – the sponsors of ETFs, brokers, and regulators – don’t want you to ever think of “that” word when you think about ETFs.
ETFs are derivatives.
There, I’ve said it. Now you know.
What They Don’t Want You to Know
An ETF doesn’t exist on its own. Every ETF is derived from other financial instruments or multiple instruments, or derivatives of financial instruments.
For example, take the SPDR S&P 500 ETF (AMEX:SPY); the biggest, most liquid, and most traded ETF in the world. The SPY ETF is derived from all 500 stocks that make up the S&P 500 index.
The prices of those 500 stocks are capitalization weighted, and it represents what it would cost an investor to “own the market” if they were to buy one share of each of the 500 stocks in the S&P 500 index.
It’s important to understand that SPY (and every other ETF) is a derivative of what securities underlie it.
And that’s where the trouble lies.
ETF shares are created from underlying securities when an ETF sponsor (the companies that own ETF families) engages an “authorized participant” (AP) to buy the right amount of underlying securities to accurately represent what the ETF is supposed to track. The AP – who can be a market-maker, a specialist, a broker-dealer, or a big financial institution – buys up the underlying securities and delivers them to the sponsor. The sponsor gives the AP an equal amount of “creation units”, AKA ETF shares. The AP then sells those units, or shares, to buyers in the open market. That’s how ETF shares come to market.
There isn’t a problem with creating more units if demand for the ETF shares is robust. If the stock market is rising and more and more investors want to buy ETF shares to join in the rally, the sponsor will have the AP buy up more underlying shares (which itself can raise prices) and turn them over to the sponsor for creation units to sell in the open market to eager buyers.
But what happens when there are more sellers than buyers? What happens to ETFs then?
What happens can be catastrophic. Especially as more and more so-called passive investing strategies call for more and more indexed ETFs to be stuffed into passive investing accounts.
Passive investing can easily be turned on its head. Just because it’s called passive investing doesn’t mean investors loaded up with ETFs won’t sell them if the market looks like it’s headed south.
After all, the idea of not trying to beat the market by buying the market (the philosophy of every passive investor) is drawing a lot of sidelined investors back into the market. The hype that being a passive investor by buying and holding stocks packaged as market indexes, is safer is a bunch of rubbish.
The market’s still going to do what the market’s going to do. And markets go down.
When the market goes down quickly investors tend to panic. If passive investors who thought they were safe start seeing their passive holdings actively falling in price, they will start actively selling them and it could turn into a bloodbath.
That’s because the way ETF units are created, is also the way they’re destroyed or reduced in number.
The Selloff Crash
Let’s say there’s a big selloff and ETF investors start selling lots of their shares. If there are no buyers for those shares, the balance between all the underlying stocks APs bought and the number of creation units that were made to equal them gets out of balance. APs then have to sell the underlying stocks (or whatever underlies the ETFs being sold) so the shares of ETFs being sold by investors can be destroyed.
Thus creates a huge negative feedback loop.
As authorized participants sell underlying shares, they are driving down those share prices. As the value of the indexes that represent those underlying shares fall, due to the heavy selling of the underlying shares, the share prices of the ETFs fall causing panicked investors to sell them. That’s when we have our negative feedback loop that can crash stocks as selling begets selling which begets selling.
All of a sudden passive investing looks like a trap.
But it gets worse.
Authorized participants are market players themselves. If they see markets falling and know they have to sell shares of underlying stocks in ETFs that are falling, they can short both the ETF shares and underlying shares of whatever the ETFs are made of to make money from falling prices.
Let me break this down. The same market-makers, specialists, and financial institutions that make money buying shares to deliver to sponsors to get creation units can force down the price of those units by shorting them and underlying shares to knock down ETF prices, to get ETF holders to sell them, to knock down prices, to make a profit when prices fall. If there’s money to be made from shorting stocks, of course the pros will try and make money doing that.
What sponsors and regulators don’t want you to know is that authorized participants have absolutely no obligation to buy the ETFs being sold in the market.
That’s right. As panicked passive investors become active sellers, APs knocking down ETF prices don’t have to buy them. They’re not buyers of last resort. If they don’t step in and buy ETF shares, of course prices can keep going down.
It’s not something passive investors buying ETFs ever think about. But they should.
We caught a glimpse of it happening in the May 2010 flash crash, in the ugly opening of the markets on August 24, 2015, and when the same thing happened to high yield ETFs in December 2015.
Those were selloffs that got “corrected” because they were contained. But we all saw what can happen and how selling ETFs and the stocks and securities that underlie ETFs affect markets on the way down.
There’s a big, ugly selloff coming. Passive investors selling their ETFs could start it, or they could make any general selloff a full-fledged crash by dumping their ETFs on the way down.
It’s not a matter of time, it’s a matter of when.
Next, I’ll tell you how to protect yourself, as best you can… And how to make a bundle when you see it coming.