October 2012 – Commentary
During October, the bond market came under pressure as investors grappled with better than expected economic data and a revival of inflation concerns. However, on-going quantitative easing provided support to the market in the final days of the month.
Friday October 19th, marked the 25th anniversary of Black Monday, the day in 1987 that the Dow Jones Industrial Average dropped more than 22%. In the months and weeks leading up to Black Monday, the U.S. was grappling with Fed uncertainty, as then Federal Reserve Chairman Greenspan was tightening monetary policy in an effort to dampen stock market exuberance. Concurrent with, and despite the tightening monetary policy, the U.S. dollar was in the midst of a multiyear slide against European economies, namely Germany, France, and the U.K., while the stock market was climbing the proverbial “wall of worry.” Feeding upon that worry, Wall Street firms were actively selling the concept of portfolio insurance as a risk management tool. Portfolio Insurance was marketed as allowing the investor to fully participate in the market as it rallied, but cut their losses in the event of a market reversal. The idea was that the investor could instantaneously exit the market by simply informing their broker to execute a program trade in which a basket of stocks were sold. For a fee, the brokerage firm would customize the basket, so that trade was loaded and ready to execute in advance of any market weakness. When the investor gave the signal, the brokerage instructed their computer to direct the sales to the Super-Dot system on the New York Stock exchange or the Auto-Ex system on the American Stock Exchange. It was explained that unlike the arcane and time consuming system of voice execution, the Super-Dot and Auto-Ex systems allow for immediate execution at then-prevailing prices. With the advantage of speed afforded by portfolio insurance, a portfolio manager would be able to get out before everyone else, as it was explained.
However, in practice, the system was deeply flawed. With so many managers participating in portfolio insurance, there was a cascading effect when everyone hit the sell button at once. Compounding that flaw was the assumption that the electronic sales would be executed in an orderly fashion. In actuality, as each sell order hit the market, the bid for additional shares automatically repriced lower. As a result, market orders were filled at lower prices than investors expected. The problem was exacerbated by the inability of the computers to process a much heavier flow of orders than had ever been expected. While trading was supposed to cease at 4:00 p.m., as usual, orders entered on the Super-Dot and Auto-Ex before the close, continued to trickle through for hours after the close. In a post-mortem of the disaster, it was concluded that the system was unable to handle the flood of orders, especially given how pervasively the portfolio insurance tool had been sold. After all was said and done, rather than mitigate risk, portfolio insurance worsened it.
With markets relatively calm and viewers seeking a respite from the seemingly endless political mudslinging, the financial media devoted much airtime on the 25th anniversary of Black Monday to the cause of the crash. Much of the focus was on portfolio insurance and the rhetorical question, does rapid-fire black box trading pose a similar risk to the market today. Given the periodic frequency of “flash crashes,” the consensus answer was a resounding yes! However, the reporters missed an equally worrying risk that has demonstrated some of the same attributes of portfolio insurance; namely, the Exchange Traded Fund (ETF) market.
The similarities between ETF’s and portfolio insurance are striking. Since the stock market bottomed in March 2009, ETF’s have proliferated and now boast assets equivalent to the largest of the large mutual funds. Touted as a low cost alternative to single stock investing with the added benefit of quickly entering and exiting the market, the sales pitch sounds eerily similar to that of portfolio insurance. Amid the enthusiasm, we believe that investors have overlooked some glaring risks.
The first risk to consider is that securities constructed in a bull market quite often overstate the demand and liquidity for the product. To understand this one must first understand that Wall Street is in the business of selling, not buying, securities. As explained in the ETF disclosure language, when investor demand exceeds supply for the shares of a specific ETF, the ETF sponsor goes into the secondary market and buys the securities to create the additional shares. In doing so, the sponsor profits from the transaction fees associated with the secondary market transactions and the expanding asset base upon which they can charge a management fee. The greater the demand, the greater the profit! Considering the alternative, in which investors panic and want to sell their ETF exposure, the dynamic is much different. Trading desks don’t like to buy securities in a falling market, and with the “Volker Rule” limiting their ability to commit anything more than nominal exposure to proprietary trading, their ability to absorb those sales is limited. In that instance, the “float” of ETF shares would need to shrink and the sponsor would be required to sell the securities that comprise the ETF back to their trading desks. In such a situation, the price decline would be exacerbated by the lack of buyers as the profit motive shifts from greed to fear. A similar situation to what happened when portfolio insurance trades were executed on Black Monday.
In addition to the hidden peril of liquidity risk, ETF’s can be deceptively expensive, despite sponsor claims that they’re a low-fee alternative to mutual funds. Again, as explained in the ETF disclosure language, owning an ETF is to own an interest in a portfolio of securities. The net asset value of the portfolio is the aggregate value of the securities held in that portfolio. While the price of the ETF usually trades at a price close to the net asset value of the portfolio, it’s based on what investors are willing to pay for the ETF, not the net asset value of the underlying securities. Quite often, in a rising price environment the price paid for the ETF is higher than the value of the underlying securities, thereby causing the ETF to trade at a premium. However, when investors rush for the exit, as discussed in the previous paragraph, it’s possible that the ETF could fall to a discount to the value of the underlying portfolio of securities, thereby worsening the performance of the investment.
Given the uncertainty posed by liquidity risk and pricing variability, investors should be cognizant of the size and mechanics of the ETF relative to the broad market. The financial press has touted the enormous size of the ETF market as an advantage, alluding that with size comes liquidity, which under normal circumstances, is accurate. However, when the worm turns and sellers want to exit, the size could cause the price to fall even faster than anticipated.
As equity investors rudely learned on Black Monday, 25 years ago, the “good idea” Wall Street sold them went dramatically wrong. While there are many positive attributes to the ETF market, to ignore the risk is to put ones portfolio in peril.