The Risk of An ETF-Driven Liquidity Crash
The comments below are an edited and abridged synopsis of an article by Lance Roberts
The rise in passive investing has been a by-product of a decade-long infusion of liquidity and loose monetary policy which fostered a rise in asset prices to an extreme valuation. Since 2009, over $2.5 trillion of equity investment has been added to passive strategy funds, while $2 trillion has been withdrawn from active-strategy funds.
The problem with even 35% of the market being passive is liquidity issues. With more ETFs than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp reversal remains due to compressed credit and liquidity risk premia. Investors need to know the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets. Passive investing works, until it doesn’t.
Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing…until it goes in the other direction.
The sell-off in February this year was not particularly unusual; however, it was the uniformity of the price moves that revealed the fallacy passive investing as investors headed for the door all at the same time. It should serve as a warning.
When robot trading algorithms begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.
Fortunately, while the price decline was sharp, it was just a correction within the ongoing bullish trend. For now. But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008, and that certainly sounds bad.