Blood and Oil

Why do you think everyone suddenly cares about some Saudi journalist?

Which of the following seems more plausible to you?

#1. The world suddenly cares deeply and passionately about human rights in Saudi Arabia. (note that this wailing and gnashing of teeth was conspicuously absent when Crown Prince Mohammed Bin Salman decided to go full Michael Corleone on the Saudi elite last year)

#2. The US financial/political/industrial complex cares deeply and passionately about inflationary pressures and what they might mean for the future path of interest rates, is irritated that the Saudis prefer a higher oil price, and has lucked into the perfect issue with which to needle Riyadh.

Forgive my cynicism, but this all strikes me as by-the-numbers geopolitical gamesmanship.

 

Weapons Of Mass Destruction?

There is this meme out there that the increasing popularity of ETFs as investment vehicles is eventually going to blow up the world. This came up in a meeting I attended recently. Whenever I have these conversations what I take away from them is that a shocking number of financial market participants do not actually understand how ETFs work.

The meme goes like this: there are too many people investing through ETFs these days and when there is a nasty bear market they will all redeem from the ETFs at the same time and the ETFs will all explode. On the off chance you’re wondering how this meme got started this graphic should set you straight.

ETF_flows
Source: ICI

As you can see, if you’re an active equity mutual fund manager you’ve got several hundred billion reasons to portray the rise of the ETF as a harbinger of doom. And so here is the first and most important thing everyone needs to know about ETFs:

ETFs are not mutual funds!

From what I can tell, the ETF-As-Weapon-Of-Mass-Destruction meme is founded on the incorrect assumption an ETF is like an open-ended mutual fund or hedge fund that needs to liquidate holdings to meet redemption requests in cash.

That’s basically the opposite of how an ETF works.

An ETF is much closer in nature to a closed-end fund that can trade at a premium or discount to net asset value over time. The difference is that certain sophisticated market participants (“authorized participants”) can transact with an ETF issuer to create or retire shares. In theory, this mechanism should keep an ETF’s share price in line with its NAV (Arbitrage 101, friends).

Here is a helpful diagram, courtesy of ICI:

ETF_create_redeem_process
Source: ICI

When individual investors like you and me want to sell ETF shares, we don’t participate in the creation/redemption process. We couldn’t participate in that process if we wanted to. Instead, we have to sell our shares in the secondary market like a stock. The price we can transact at is determined by supply and demand. This can be a blessing or a curse, depending on circumstances.

Some Grains of Truth

ETF investors do face risks as they transact in the secondary market. The biggest risk is that they become forced sellers when the market for a particular ETF is thinly traded. In that case, they’ll have to take a haircut to unload their shares. This is no different from what happens when someone tries to unload shares of an individual stock in an illiquid market. That’s Trading 101.

Thus, if you’re going to invest in ETFs you need to pay attention to liquidity. This goes for your personal liquidity (under what conditions might I become a forced seller of this security?) as well as market liquidity (are bid-offer spreads for this security going to stay reasonably tight across a range of market conditions?).

If, for example, you own the S&P 500 index in ETF form you probably don’t have much to worry about from a liquidity standpoint. This won’t protect you from behaving like an idiot as an individual, but it’s fairly unlikely you will ever have to part with your ETF shares at a 50% discount to NAV. In fact, the early S&P 500 ETFs have been battle-tested across a number of stressed market environments, including the global financial crisis. They have yet to explode.

If you own more esoteric things, however, (e.g. the EGX 30 index, high yield debt, bank loans, complicated VIX derivatives) you need to think carefully about liquidity. Shrewd traders will eat you alive if you try to unload esoteric stuff in a dislocated market. In general, it’s dangerous to assume a share of something can ever be more liquid than the stuff it owns or represents. Yes, bank loan and high yield ETF investors, I’m looking at you here.

But these risks aren’t unique to ETFs. They’re present with every exchange traded security. It’s just that mutual fund investors aren’t used to thinking about this stuff. They just buy or redeem each day at NAV.

In Conclusion

Never generalize about any security or type of security.

Securities are not inherently good or bad. Investing is not a morality play.

In fact, any time someone is presenting a security or investment philosophy as a black/white, good/bad, dualistic type of situation it’s a good sign he’s financially incentivized to sell you something.

There are smart ways to use ETFs and stupid ways to use ETFs. But that’s more a comment on investor behavior and specific implementations of ETF investment strategies than the structure itself.

You Have To Earn It

Personally, I’m relieved to see market volatility pick up again.

I’m sick of all this feel-good, bull market crap where everyone can be investing geniuses as long as they focus on the “long term” and own the lowest cost, most tax efficient index funds. It’s high time some volatility comes along and shakes some weak hands out of the market.

People want to live in a riskless world where all the market ever does is go up. You know what kind of returns you are entitled to in a riskless world where all the market ever does is go up?

T-bills.

(Arbitrage 101, friends)

Lately, we’ve gone soft. We’ve forgotten good investment returns aren’t some god-given, inalienable right. Good returns must be earned. And here are some ways you can earn them:

  • By being so far ahead of a secular shift in technology or market structure that everyone else thinks you’re insane.
  • By investing in esoteric stuff no one else can sell to an investment committee.
  • By putting money to work when the world looks to be going to hell in a hand basket.
  • By enduring short and medium-term pain in unloved assets.
  • In spite of inevitable blowups and meltdowns in individual investments.
  • More generally, by persevering when fear and loathing reign supreme in the markets.

Whenever volatility picks up and people start freaking out, I’m reminded of Nick Murray’s definition of a bear market: “a period when stocks are returned to their rightful owners.”