To Be Passive Is to Let Others Decide for You

Romain/ avril 27, 2020/ Finance/ 9 comments

‘The greatest trick the devil ever pulled was convincing the world he didn’t exist.’
Keyser Soze

In 2008, the financial system was hit by a severe liquidity crunch for two main reasons. On the one hand, people dramatically underestimated the real underlying risk of securitized products. On the other hand, financial institutions made dangerous bets by selling insurance contracts on those asset-backed securities.

I already published a post about volatility spikes risks (see Stranger Things) so let’s talk about the first issue.

During the 2000’s, RMBS and CDOs had become very popular in the financial industry. Those products enabled to generate decent returns by betting on the US housing market boom without having to analyze the profiles of thousands to millions of American households.

They were divided into several tranches with different level of risk. The safest ones (i.e. senior tranches) looked very attractive for money fund managers, offering better yields than traditional AAA bonds with the same level of risk.

The crisis started when people realized that those ‘risk-free’ tranches were actually riskier than previously thought because of too many defaults among the subprime segment. All the loans were not underperforming, but the CDO market had reached a size that had nothing to do anymore with the original mortgage loans. Moreover, the level of concentration on those securitized products was so high that it led to a significant derating of senior tranches prices with no more buyer on the horizon.

Dr Michael Burry is one of the few persons who understood this critical situation before the dislocation. More interestingly, he recently made a parallel between current Exchange-Traded Funds (ETF) and the CDO market, warning on equivalent liquidity problems in the future because of passive investing.

Therefore, the crash of WTI futures contract should not come as a surprise, since one of the main drivers of this sell-off was the fact that oil ETFs were force to liquidate their positions (see Who Was Panic Selling Oil Today? Goldman Answers).

ETF Flows and Concentration Risk

This is what you get when you add too many passive flows. They create a large disconnection with economic needs and many of those funds do not even hold the underlying assets.

Beyond commodity markets, the real game changer for the financial system could be the size of US stocks ETFs. Those funds have become so popular among both institutional and retail investors, that they have led to significant distortions on equity markets.

The main problem is the heavy market concentration on five single companies: Amazon, Apple, Google, Facebook, and Microsoft. Big tech firms now account for more than 20% of the total market capitalization of the S&P 500. And a social media company like Facebook is now more capitalized than the whole American capital goods industry.

Why is everyone buying Nasdaq or S&P 500 ETFs? Maybe because the value proposition looks attractive. On average you should get a better return than most active equity funds, but with very low fees, no specific risk and thus no financial analysis requirement. Except that the absence of company-related risk becomes questionable when five stocks account for 22% of the index…

Remember that the pretty same logic applied to residential mortgage backed securities: you were supposed to get higher yields with no additional risk and no analytical work.

But there is no such thing as a free lunch. In finance, you do not make a better performance without taking more risk. So, there might be hidden problems somewhere.

To make a full comparison with CDOs, US passive equity funds could be divided into three types of tranches: Russell Midcap would be the equity tranches, S&P 500 would be the mezzanine tranches and Nasdaq would be the senior tranches.

Of course, Amazon and Microsoft are big and beautiful machines which are very unlikely to fail soon. However, their valuation has become so stretched that there is no more space for bad news. What’s more, the market concentration on those names have become so high that any significant outflow affecting ETFs could lead to a funnel effect.

Markets seems to behave like birds murmuration, i.e. a large decentralized crowd of investors quietly flying in a direction. And then, without any warning sign, a few participants lead the others the other side.

When too many people hold the same asset, the question is, will there be enough liquidity to sell in good conditions? Will the Federal Reserve become the main shareholder of Amazon tomorrow?

This article was originally published on LinkedIn April 22, 2020.

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