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How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it t

by mrep 7y ago

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid. [0]: https://www.investopedia.com/terms/a/authorizedparticipant.asp https://www.investopedia.com/terms/a/authorizedparticipant.a...

pjmorris 7y ago
> basically need the entire market to become illiquid. Which came dramatically close to happening in 2008, see, e.g. [0]. [0] http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_schnabl.pdf http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_sch...
josu 7y ago
>You'd basically need the entire market to become illiquid. Yes. It has happened before.
- asdkfjasl 7y ago
  OK, but in that case is there a distinction between index funds and actively managed funds? Is this a risk that index funds are uniquely exposed to? Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.
  - JumpCrisscross 7y ago
    > in that case is there a distinction between index funds and actively managed funds? Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze. > this only affects people who are trying to sell at the bottom There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio. Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.
    - Mathnerd314 7y ago
      There are some escape clauses in Vanguard's index funds: The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest. ... Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. And a lot of index fund investors are buy-and-hold so it's unclear if a recession would even cause a liquidity / redemption crisis.
      - deleted 7y ago
        [deleted]
      - JumpCrisscross 7y ago
        > And a lot of index fund investors are buy-and-hold But index funds themselves aren't. They have to sell stock when units are destroyed and vice versa. In addition to other factors, this can result in weird tax effects as well as tracking error to the index.
  - thanatropism 7y ago
    Well, 1) To track the actual index, index funds must continually rebalance their portfolio. In a liquidity pause they may not be able to do this, thereby becoming a non-index fund. Actively managed funds have the portfolio they have -- unless they're defrauding the public somehow. An index fund that becomes a non-index fund would fall in this latter category. 2) The index (not the funds) is assumed to reflect all the information that can be used to make some money by arbitrage. This process is referred as "price discovery". But in a liquidity pause, price discovery grinds to a halt. Actively managed funds have their own idea of what are the fundamental prices beyond what the public leaderboard says; their price discovery is not beholden to the existence of a liquidity market. Actually -- if the market goes for years with very low liquidity, it becomes more likely that people who, say, are shorting Herbalife for fundamental reasons, have more knowledge than the index. In this way the index is like an AI that can become starved for data.
dcolkitt 7y ago
Burry's point wasn't that the ETFs would lose liquidity, but rather than the lightly-traded names in the index would. If the index instruments have a lot more liquidity than the underlying names, then that means they won't be able to gracefully absorb the liquidity shocks from an unwind in the index. Here's some back of the envelope calculations. Between SPY, IVV, and VOO alone, there's $500 billion in S&P 500 index ETFs. Consider if an unwind event leads to 20% of index assets being redeemed in a single day. That's $100 billion from the above ETFs alone. Now consider a typical thinly traded single-name stock like Chubb Limited (symbol CB). CB makes up 0.3% of the S&P 500 by weight. So in the hypothetical scenario above, the APs would have to collectively sell $300 million worth of CB in a single day. Chubb's entire ADV is only $238 million. Trying to sell more than 100% of a stock's ADV in a single day is guaranteed to produce huge market impact. The current liquidity providers in CB almost certainly cannot absorb that amount of trading volume all in one direction. In that scenario, Chubb's stock might fall by 20%, for something that had nothing to do with the company itself. I think the overall point is that a lot of single-name stocks nowadays don't really have much of an individual market. Names like TSLA, FB or TEVA definitely have a robust market with a lot of traders still focused on company specifics. But a lot of the more boring, lower volatility, mid-cap stocks (like CB) mostly just trade along with the index nowadays. If there are technicals related to index capital flows, stocks like that are going to get taken for a ride. [1] https://www.etf.com/channels/sp-500-etfs https://www.etf.com/channels/sp-500-etfs [2] https://www.slickcharts.com/sp500 https://www.slickcharts.com/sp500 [3] https://finance.yahoo.com/quote/CB?p=CB https://finance.yahoo.com/quote/CB?p=CB
- Raidion 7y ago
  This is a really good explanation, but you would think market forces would kick in. If a company drops 20% (or even 3%!) from an event that doesn't effect the business itself, you're going to get smart money buying. I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. This is under the assumption that there will be capital available to flow, if there isn't because of a truly bad scenario, yes it's a downward spiral, but it will take quite an event to get us to that point.
  - 7y ago
prostoalex 7y ago
> Even if one of the underlying stocks becomes illiquid Burry’s money quote in the original Bloomberg article was on limited liquidity for a largish number of stocks - over a 1,000 stocks in Russell 2,000 weren’t traded heavily (by his benchmark).

by mrep 7y ago

pjmorris 7y ago

> basically need the entire market to become illiquid. Which came dramatically close to happening in 2008, see, e.g. [0]. [0] http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_schnabl.pdf http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_sch...

josu 7y ago

>You'd basically need the entire market to become illiquid. Yes. It has happened before.

asdkfjasl 7y ago
OK, but in that case is there a distinction between index funds and actively managed funds? Is this a risk that index funds are uniquely exposed to? Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.
- JumpCrisscross 7y ago
  > in that case is there a distinction between index funds and actively managed funds? Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze. > this only affects people who are trying to sell at the bottom There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio. Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.
  - Mathnerd314 7y ago
    There are some escape clauses in Vanguard's index funds: The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest. ... Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. And a lot of index fund investors are buy-and-hold so it's unclear if a recession would even cause a liquidity / redemption crisis.
    - deleted 7y ago
      [deleted]
    - JumpCrisscross 7y ago
      > And a lot of index fund investors are buy-and-hold But index funds themselves aren't. They have to sell stock when units are destroyed and vice versa. In addition to other factors, this can result in weird tax effects as well as tracking error to the index.
- thanatropism 7y ago
  Well, 1) To track the actual index, index funds must continually rebalance their portfolio. In a liquidity pause they may not be able to do this, thereby becoming a non-index fund. Actively managed funds have the portfolio they have -- unless they're defrauding the public somehow. An index fund that becomes a non-index fund would fall in this latter category. 2) The index (not the funds) is assumed to reflect all the information that can be used to make some money by arbitrage. This process is referred as "price discovery". But in a liquidity pause, price discovery grinds to a halt. Actively managed funds have their own idea of what are the fundamental prices beyond what the public leaderboard says; their price discovery is not beholden to the existence of a liquidity market. Actually -- if the market goes for years with very low liquidity, it becomes more likely that people who, say, are shorting Herbalife for fundamental reasons, have more knowledge than the index. In this way the index is like an AI that can become starved for data.

dcolkitt 7y ago

Burry's point wasn't that the ETFs would lose liquidity, but rather than the lightly-traded names in the index would. If the index instruments have a lot more liquidity than the underlying names, then that means they won't be able to gracefully absorb the liquidity shocks from an unwind in the index. Here's some back of the envelope calculations. Between SPY, IVV, and VOO alone, there's $500 billion in S&P 500 index ETFs. Consider if an unwind event leads to 20% of index assets being redeemed in a single day. That's $100 billion from the above ETFs alone. Now consider a typical thinly traded single-name stock like Chubb Limited (symbol CB). CB makes up 0.3% of the S&P 500 by weight. So in the hypothetical scenario above, the APs would have to collectively sell $300 million worth of CB in a single day. Chubb's entire ADV is only $238 million. Trying to sell more than 100% of a stock's ADV in a single day is guaranteed to produce huge market impact. The current liquidity providers in CB almost certainly cannot absorb that amount of trading volume all in one direction. In that scenario, Chubb's stock might fall by 20%, for something that had nothing to do with the company itself. I think the overall point is that a lot of single-name stocks nowadays don't really have much of an individual market. Names like TSLA, FB or TEVA definitely have a robust market with a lot of traders still focused on company specifics. But a lot of the more boring, lower volatility, mid-cap stocks (like CB) mostly just trade along with the index nowadays. If there are technicals related to index capital flows, stocks like that are going to get taken for a ride. [1] https://www.etf.com/channels/sp-500-etfs https://www.etf.com/channels/sp-500-etfs [2] https://www.slickcharts.com/sp500 https://www.slickcharts.com/sp500 [3] https://finance.yahoo.com/quote/CB?p=CB https://finance.yahoo.com/quote/CB?p=CB

Raidion 7y ago
This is a really good explanation, but you would think market forces would kick in. If a company drops 20% (or even 3%!) from an event that doesn't effect the business itself, you're going to get smart money buying. I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. This is under the assumption that there will be capital available to flow, if there isn't because of a truly bad scenario, yes it's a downward spiral, but it will take quite an event to get us to that point.
- 7y ago

prostoalex 7y ago

> Even if one of the underlying stocks becomes illiquid Burry’s money quote in the original Bloomberg article was on limited liquidity for a largish number of stocks - over a 1,000 stocks in Russell 2,000 weren’t traded heavily (by his benchmark).