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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

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.
- AlanYx 7y ago
  The "smart money" would start buying, but I imagine the concern is that as passive instruments become the majority of the market, there wouldn't be a deep enough pool of assets held by "smart money" to provide offsetting liquidity in the way you describe.
  - mox1 7y ago
    But wouldn't this reach some sort of equilibrium point? IE if a smart person with a lot of money think there is no "smart money" left, wouldn't (s)he just start their own smart money hedge fund to provide / do this? If nobody is left to do thing X AND thing X is basically guaranteed profit, isn't it natural for people to step in and do thing X?
    - pas 7y ago
      But we already have that. Gold. Or CHF. The problem is that it takes roughly 10 years to outshine the stock market.
  - SubiculumCode 7y ago
    I know next to nothing about investing, but I thought the article said that passive instruments are a very small portion of the market...and also that in house indexing has always been a thing.
  - chawco 7y ago
    But doesn't it seem like that, as total ownership of the market shifts towards passives, higher returns would be driven by funds running active strategies such as these, thus making them more attractive investments? It seems like this sort of thing chases an equilibrium.
- dcolkitt 7y ago
  > I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting. E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock. Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release. Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk. The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio. [0] http://web.mit.edu/Alo/www/Papers/august07.pdf http://web.mit.edu/Alo/www/Papers/august07.pdf
all_blue_chucks 7y ago
Doesn't the "circuit breaker" process on the stock exchange exist for this scenario? To give people time to line up buyers when there is a sudden unexpected repricing?
- asdf333 7y ago
  yes, possibly. but i think that may feed back into some weirdness for the index funds "i'm supposed to sell 500m of this small stock but i only got to sell 300m before it was frozen out...now my basket of holdings is slightly off from the actual index...hopefully i can rectify it tomorrow..."
domnomnom 7y ago
I hate when people use acronyms without first defining them, they are literally impossible to google. What is ADV?
- aynyc 7y ago
  Average Daily Volume
jonknee 7y ago
Yes, if indexes sell off any many times their average daily volume that means components will as well. That's fine. If something happens where people are selling the S&P 500 down 20% in a single trading session (the full day circuit breaker limit) there should be chaos amongst the components because shit has hit the fan. Savvy players will scoop up deals, most people will do nothing and life will move on.
hyperpape 7y ago
This is a great explanation. Can you explain why this isn't a problem for actively managed funds, though? Do they just avoid stocks like CB?
- dcolkitt 7y ago
  No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock. Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations. But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors. As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.
  - hyperpape 7y ago
    I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active funds scenario, what you're describing in the previous post doesn't happen? Why doesn't a 20% marketwide downturn cause chaos in these smaller stocks? Is it because there would be higher volumes if those stocks were held by active funds? Or because the active funds wouldn't hold stocks like that? Basically, I'm asking for a comparison of the scenario you described with what happens in a no-index world, because I can't quite think through the difference myself.
    - 7y ago

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.

AlanYx 7y ago
The "smart money" would start buying, but I imagine the concern is that as passive instruments become the majority of the market, there wouldn't be a deep enough pool of assets held by "smart money" to provide offsetting liquidity in the way you describe.
- mox1 7y ago
  But wouldn't this reach some sort of equilibrium point? IE if a smart person with a lot of money think there is no "smart money" left, wouldn't (s)he just start their own smart money hedge fund to provide / do this? If nobody is left to do thing X AND thing X is basically guaranteed profit, isn't it natural for people to step in and do thing X?
  - pas 7y ago
    But we already have that. Gold. Or CHF. The problem is that it takes roughly 10 years to outshine the stock market.
- SubiculumCode 7y ago
  I know next to nothing about investing, but I thought the article said that passive instruments are a very small portion of the market...and also that in house indexing has always been a thing.
- chawco 7y ago
  But doesn't it seem like that, as total ownership of the market shifts towards passives, higher returns would be driven by funds running active strategies such as these, thus making them more attractive investments? It seems like this sort of thing chases an equilibrium.
dcolkitt 7y ago
> I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting. E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock. Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release. Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk. The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio. [0] http://web.mit.edu/Alo/www/Papers/august07.pdf http://web.mit.edu/Alo/www/Papers/august07.pdf

all_blue_chucks 7y ago

Doesn't the "circuit breaker" process on the stock exchange exist for this scenario? To give people time to line up buyers when there is a sudden unexpected repricing?

asdf333 7y ago
yes, possibly. but i think that may feed back into some weirdness for the index funds "i'm supposed to sell 500m of this small stock but i only got to sell 300m before it was frozen out...now my basket of holdings is slightly off from the actual index...hopefully i can rectify it tomorrow..."

domnomnom 7y ago

I hate when people use acronyms without first defining them, they are literally impossible to google. What is ADV?

aynyc 7y ago
Average Daily Volume

jonknee 7y ago

Yes, if indexes sell off any many times their average daily volume that means components will as well. That's fine. If something happens where people are selling the S&P 500 down 20% in a single trading session (the full day circuit breaker limit) there should be chaos amongst the components because shit has hit the fan. Savvy players will scoop up deals, most people will do nothing and life will move on.

hyperpape 7y ago

This is a great explanation. Can you explain why this isn't a problem for actively managed funds, though? Do they just avoid stocks like CB?

dcolkitt 7y ago
No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock. Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations. But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors. As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.
- hyperpape 7y ago
  I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active funds scenario, what you're describing in the previous post doesn't happen? Why doesn't a 20% marketwide downturn cause chaos in these smaller stocks? Is it because there would be higher volumes if those stocks were held by active funds? Or because the active funds wouldn't hold stocks like that? Basically, I'm asking for a comparison of the scenario you described with what happens in a no-index world, because I can't quite think through the difference myself.
  - 7y ago