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ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Janus ETFs

Everybody adapts, including institutional investors like Janus.

Rattle off a top-ten list of the best active stock pickers visited by teams of company execs and investor-relations pros trundling through the airports and cities of America, and Denver’s Janus likely makes the cut.

Ah, but.  In 2014 Janus bought VelocityShares, purveyor of synthetic exchange-traded products.  Just as a drug manufactured in a laboratory rather than from the plant that first formed its mechanism of action is a replica, so are these lab-made financial instruments. They replicate the act of investment without actually performing it.

It’s neither good nor bad per se, as I explained yesterday to the NIRI San Diego chapter. But synthetics are revolutionizing how public stocks trade – without owning public stocks. Describing its effort at adaptation, Janus says on its website that it’s “committed to offering distinctive strategies for today’s complex market environment. Leveraging almost a half century of investment experience, we are now pleased to make our expertise available through Exchange Traded Funds.”

Janus says it’s intending to offer a range of returns beyond simple capital-appreciation, including “volatility management” and “uncorrelated returns.” Janus’s VelocityShares directed at volatility aim to produce enhanced or inverse returns on the VIX, an index called the “fear gauge” for reflecting volatility in forward rights to the S&P 500.

But traders and investors don’t fear volatility. They invest in it.  On Monday May 16, four of the top 20 most actively traded stocks were exchange-traded products leveraging the VIX.  Those offered by Janus aren’t equity investments but a debt obligation backed by Credit Suisse. Returns derive from what is best described as bets using derivatives.

The prospectus for the most active version is 174 pages, so it’s hard to decipher the nature of wagers. It says: “We expect to hedge our obligations relating to the ETNs by purchasing or selling short the underlying futures, listed or over-the-counter options, futures contracts, swaps, or other derivative instruments relating to the applicable underlying Index…and adjust the hedge by, among other things, purchasing or selling any of the foregoing, at any time and from time to time, and to unwind the hedge by selling any of the foregoing, perhaps on or before the applicable Valuation Date.”

Got that?  Here’s my attempt at translation: “We’ll do the exact opposite of whatever return we’ve promised you, to keep from losing money.”

During the mortgage-related financial crisis there was a collective recoil of horror through media and into Congress that banks may have been betting against their clients. Well, come on.  It’s happening in equities every day!  Exactly how do we think somebody who says “sure, I’ll take your bet that you can make double the index without buying any assets” can possibly make good without farming the risk out to someone else?

In the mortgage crisis we learned about “credit default swaps” and how insurers like AIG were on the hook for hundreds of billions when real estate stopped rising. Who is on the hook for all these derivatives bets in equities if stocks stop rising? It’s the same thing.

Last Friday the 13th, five of the top 20 most actively traded instruments on the Nasdaq and NYSE were synthetic exchange-traded products attempting to produce outsized returns without correlating to the market. That’s 25% of the action, in effect.

For stock-picking investors and public companies it means a significant contingent of price-setting trades in the stock market are betting on moves uncorrelated to either fundamentals or markets. You’ll find no explanation in ownership-change.

What do you tell management and Boards about a market where, demonstrably, top price-setting vehicles like TVIX owned by conventional stock-pickers aren’t buying or selling stock but betting on tomorrow’s future values using derivatives?

In fact, everyone is betting against each other – traders, banks, investors. I take you back to the mortgage-backed securities crisis. The value of underlying assets was massively leveraged through derivatives the values of which bore no direct connection to whether mortgages were performing assets.  That by any definition is credit-overextension. A bubble.  A mania. Then homes stopped appreciating. The bubble burst two years later.

Look at stocks. They’ve not risen since Nov 2014. Is anyone out there listening or paying attention to the derivatives mess in equities?

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)

Driverless Market

Suppose you were human resources director for a fleet of driverless taxis.

As Elon Musk proposes streets full of autonomous autos, the market has become that fleet for investors and investor-relations professionals.  The market drives itself. What we measure as IR professionals and investors should reflect a self-driving market.

There’s nothing amiss with the economy or earnings. About 78% of companies reporting results so far this quarter, FactSet says, are beating expectations, a tad ahead of the long-term average of 72%.

But a closer look shows earnings unchanged from a year ago. In February last year with the market anticipating earnings goosed by the corporate tax cut of 2017, stocks plunged, and then lurched in Q3 to heights we’re now touching anew, and then nosedived in the fourth quarter.

An honest assessment of the market’s behavior warrants questioning whether the autonomous vehicle of the market has properly functioning sensors. If a Tesla sped down the road and blew a stop sign and exploded, it would lead all newscasts.

No matter the cacophony of protestations I might hear in response to this assertion, there is no reasonable, rational explanation for the fourth-quarter stock-implosion and its immediate, V-shaped hyperbolic restoration. Sure, stocks rise and fall (and will do both ahead). But these inexplicable bursts and whooshes should draw scrutiny.

Investor-relations professionals, you are the HR director for the driverless fleet. You’re the chief intelligence officer of the capital markets, whose job encompasses a regular assessment of market sensors.

One of the sensors is your story.  But you should consistently know what percentage of the driving instructions directing the vehicle are derived from it.  It’s about 12% marketwide, which means 88% of the market’s navigational data is something else.

Investors, the same applies. The market is as ever driven by its primary purpose, which is determined not by guesses, theory or tradition, but by what dominates price-setting.  In April, the dominating behavior is Exchange-Traded Funds.  Active investment was third of four big behaviors, ahead only of Fast Trading (curious, as Fast Traders avoid risk).

ETF shares are priced by spreads versus underlying stocks. Sure, investors buy them thinking they are consuming pooled investments (they’re not). But the motivation driving ETFs is whether they increase or decrease in price marginally versus stocks.

ETF market-makers supply stocks to a sponsor like Blackrock, which grants them authority to create an equal value of ETF shares to sell into the market. They aim to sell ETFs for a few basis points more than the value of exchanged shares.

The trade works in reverse when the market-maker borrows ETF shares to return to Blackrock in exchange for a group of stocks that are worth now, say, 50 basis points more than the stocks the market-maker originally offered.

If a market-maker can turn 30-50 basis points of profit per week this way, it’s a wildly winning, no-risk strategy. And it can and does carry the market on its updraft. We see it in patterns.

If it’s happening to your stock, IR professionals, it’s your job to know. Investors, you must know too, or you’ll draw false conclusions about the durability of cycles.

Big Market Lesson #1 in 2019: Learn how to measure behaviors. They’re sensors. Watch what’s driving your stock and the market higher (or lower – and yes, we have a model).

Speaking of learning, IR people, attend the 50th Anniversary NIRI Annual Conference. We have awesome content planned for you, including several not-to-be-missed market-structure sessions on hedge funds, the overall market, and ETFs.  Listen for a preview here and see the conference agenda here.  Sign up before May 15 for the best rate.

Big Market Lesson #2: Understand what stops a driverless market.

ETF-led rallies stall when the spread disappears. We have a sensor for that at ModernIR, called Market Structure Sentiment™ that meters when machines stop lifting or lowering prices.

It’s a 10-point scale that must remain over 5.0 for shares to rise. It’s averaged 6.2 since Jan 8 and has not been negative since. When it stalls, so will stocks, without respect to earnings or any other fundamental sensor.

I look forward to driverless cars. But we’ll want perfected technology before trusting them. The same should apply to a driverless stock market.

 

Melting Up

Blackrock CEO Larry Fink sees risk of a melt-up, not a meltdown for stocks.

Speaking of market structure, I’m a vice chair for NIRI’s Annual Conference – the 50th anniversary edition.  From the opening general session, to meeting the hedge funds, to a debate on how ETFs work, we’ve included market structure.  Catch a preview webcast on So-So Thursday, Apr 18, (before Good Friday) at 2pm ET (allow time to download Adobe Connect): https://niri.adobeconnect.com/webinar041819

Back to Larry Fink, is he right?  Who knows. But Blackrock wants to nudge record sidelined retail and institutional cash into stocks because revenues declined 7%.

Data tell us the market doesn’t need more buyers to melt up. Lipper said $20 billion left US equities from Jan through Apr 3, more than the $6 billion Bloomberg had earlier estimated. Stocks rallied 16%.

We wrote April 3 that no net cash fled equities in Q4 last year when the market corrected. If stocks can plunge when no money leaves and soar when it does, investors and public companies should be wary of rational expectations.

We teach public companies to watch for behavioral data outside norms.  Investors, you should be doing the same. Behavioral-change precedes price-change.  It can be fleeting, like a hand shoved in a bucket of water. Look away and you’ll miss the splash.

Often there’s no headline or economic factor because behaviors are in large part motivated by characteristics, not fundamentals.

Contrast with what legendary value investor Benjamin Graham taught us in Security Analysis (1934) and The Intelligent Investor (1949): Buy stocks discounted to assets and limit your risk.

The market is now packed with behaviors treating stocks as collateral and chasing price-differences. It’s the opposite of the Mr. Market of the Intelligent Investor. If we’re still thinking the same way, we’ll be wrong.

When the Communication Services sector arose from Technology and Consumer Discretionary stocks last September, the pattern of disruption was shocking. Unless you saw it (Figure 1), you’d never have known markets could roll over.

Larry Fink may think money should rush in (refrains of “fools rush in…”) because interest rates are low.  Alan Greenspan told CNBC last week there’s a “stock market aura” in which a 10% rise in stocks corresponds to a 1% increase in GDP. Stocks were down 18% in Q4, and have rebounded about 16%. Is the GDP impact then neutral?

To me, the great lesson for public companies and investors is the market’s breakdown as a barometer for fundamentals.  We’ve written why. Much of the volume driving equities now reacts to spreads – price-differences.

In a recent year, SPY, the world’s largest and oldest Exchange Traded Fund, traded at a premium to net asset value 62% of the time and a discount 38% of the time. Was it 2017 when stocks soared?  No, it was 2018 when SPY declined 4.5%.

Note how big changes in behavioral patterns correspond with market moves. The one in September is eye-popping. Patterns now are down as much as up and could signal a top.

SPY trades 93% of the time within 25 basis points of NAV, but it effectively never trades AT net-asset-value. Comparing trading volume to creations and redemptions of ETF shares, the data suggest 96% of SPY trading is arbitrage, profiting on price-differences.

This is the stuff that’s invaded the equity market like a Genghis Kahn horde trampling principles of value investment and distorting prices.

So, what do we DO, investors and public companies?

Recognize that the market isn’t a reliable barometer for rational thought. If your stock fell 40% in Q4 2018 and rebounded 38% in Q1, the gain should be as suspect as the fall.

Ask why. Ask your exchange. Ask the regulators. Ask the business reporters. These people should be getting to the bottom of vanishing rationality in stocks.

It may be the market now is telling us nothing more than ETFs are closing above net asset value and ETF market-makers are melting stocks up to close that gap.  That could be true 62% of the time, and the market could still lose 20% in two weeks.

When you hear market-behavior described in rational terms – even during earnings – toss some salt over a shoulder.  I think the market today comes down to three items: Sentiment reflecting how machines set prices, shorting, and behavioral change.

Behavioral patterns in stocks now show the biggest declines since September. Sentiment reflecting how machines set prices is topped ahead of options expirations that’ll be truncated by Good Friday. Shorting bottomed last week and is rising.

(Side note: patterns don’t vary during earnings. They fluctuate at month-ends, quarter-ends and options-expirations, so these are more powerful than results.)

Nobody knows the future and we don’t either. Behaviors change. But the present is dominated by characteristics, powerful factors behind behavioral patterns.

Bad Liquidity

JP Morgan’s global head of macro quant and derivatives research (if you have that title, you should be a big deal!), Marko Kolanovic, says the market’s rising propensity toward violent moves up and down reflects bad liquidity.

Bad Liquidity would be a great name for a rock band. But what’s it mean?

Most measure volatility with the VIX.  The trouble with it predictively is it’s not predictive. It spikes after the fact, not ahead.

It was not always so. Modern Portfolio Theory (MPT), a hot investment thesis of the 1990s stock market, said rising volatility reflected growing price uncertainty. Managers like Louis Navellier flew private jets on fortunes made shifting from stocks as volatility mounted.

I’d argue it’s the opposite now. When volatility vanishes, arbitrage opportunities, the primary price-discovery mechanism today (“price discovery” means “trying to figure out the price of a thing”), have been consumed. What happens then? Money leaves.

Speaking of money leaving, Mr. Kolanovic blames falling Active investment for a lack of liquidity. He says algorithm

Image shows weekly spreads between composite stocks and State Street sector SPDR ETFs, with negative numbers indicating more volatility in ETFs, positive numbers, more volatility in composite sector stocks.

s – “stock recipes” run by computers – are present when markets rise and absent when markets fall, exacerbating liquidity shortages.

Active investors tend to sell when prices are high and buy when they’re low, helping to ease liquidity constraints. As Active investment declines (he says just 10% of trading, presumably he means at JP Morgan, comes from Active stock-picking, eerily near the figures we measure – with algorithms no less), stabilizing liquidity shrinks.

Liquidity boiled down (so to speak!) is the availability of a thing at a stable price.  The more that’s available, the better your chance of getting it at the same price.

Investors tend to want a lot of something – a truckload.  Arbitragers tend to want the price to change. These aims are diametrically opposed.

By the way, I’m speaking to the NIRI Minneapolis chapter today on Exchange Traded Funds, which are predicated on an arbitrage mechanism. That means they can only exist as investment instruments if there is volatility. Mr. Kolanovic thinks volatility is the root rot.  Connection?

Yes. ETFs distort liquidity in two crucial ways that compound risk for stocks. As we’ve explained, ETFs are not pooled investments. They are most closely akin to put and call options, in that they are created when people want more of them and removed from the market when people don’t want them.

As with puts and calls, they become ends unto themselves. Too many mistake options prices for future stock prices. Sometimes that’s true. But changes in the value of options are a discrete profit opportunity themselves.

Goldman Sachs wrote in February this year as Q4 2018 results were coming in (thank you to an alert reader!): “What’s interesting this quarter is that buying calls for earnings reports has posted its best return in over thirteen years (record). In fact, buying the closest out of the money call 5 days ahead of earnings and closing the day after has produced an average return of 88%.”

Eighty-eight percent! That’s not a bet on results but pure arbitrage in options.

ETFs offer the same opportunity. Shares are created when investors want exposure to equities and redeemed when investors want out. But the investors to a large extent now are ETF market-makers profiting on spreads between ETFs and the underlying stocks comprising a tracking instrument. It’s arbitrage. Profiting on price-differences.

The problem with this liquidity is it’s continuously fluctuating. We can have no consistent, measurable idea of the supply of ETFs or the demand for stocks. That means the market at any given time cannot be trusted to provide meaningful prices.

The data to me say it’s the arbitrage mechanism in ETFs behind bad liquidity. ETFs can only establish prices through spreads with stocks. The market is now stuffed with ETFs. The motivation is the spread. Not fundamentals – or even fund-flows.

We track spreads between ETFs and composite stocks. Our data say spreads totaled hundreds of percentage points from Dec 2018 to Mar 2019. At Apr 5, stocks are 33% more volatile in 2019 on net than ETFs. That’s way more than the market has risen.  Somebodies will want to keep it.

If we want to know where the next financial crisis will develop, we need look no further than ETFs. They are now a mania. They depend on spreads. As liquidity goes, that’s bad.

Beating Hearts

As the Dow Jones Industrials surged over 300 points on April Fools Day, the behavior driving it was Exchange Traded Funds, not rational thought reacting to economic data.

But aren’t ETFs manifestations of rational thought? Investors see, say, good Chinese manufacturing data, and pump money into them?

I’m not talking about fund flows.  I’ll explain.

CNBC reported that investors withdrew about $6 billion from stock funds during the first quarter’s epic equity rally. How can stocks soar when money is leaving?

We wrote Mar 20 that tallying fund-flow data in Q4 2018 when the market fell about 20% showed net static conditions. That is, $370 billion left stock-picking portfolios and the same amount shifted to passive funds. If no money left, why did stocks crater?

We should ask why fund flows don’t match market-performance. It seems like everyone is running around with fingers in ears going, “La la la la!” amid these uncomfortable realities.

Bloomberg wrote a wildly compelling piece on “heartbeat trades” Mar 29, taking a cue from FactSet’s Elisabeth Kashner, who first wrote about this ETF phenomenon in late 2017.

The gist is that ETFs somehow get short-term cash or stocks to finance creating ETF shares, which go to the provider of the loan as collateral, and then days later the ETF sponsor provides the bank with high capital-gains stocks equal to the value of the ETF shares, which it receives back.

Follow that?  Money is traded for ETF shares, which in turn are traded for stocks.

(Note: We should also wonder where those stocks came from if the market doesn’t suddenly take a selling hit afterward. Were they borrowed to start?)

The result of this trade is that taxes associated with the stocks are washed out of the ETF portfolio, ostensibly benefiting ETF investors.

Except ETF investors don’t own a share of pooled assets carrying tax liabilities. ETFs are not backed by any assets. The assets moving back and forth between, say, Blackrock and Goldman Sachs in these heartbeat trades belong to Blackrock, not to investors.

So Blackrock gets a tax benefit.

If you as an investor sell appreciated ETF shares, you owe taxes. That is, if you bought ETFs for $20 per share and they go to $30, and you sell them, you have $10 of gains and you’ll owe either ordinary-income or capital-gains taxes.

Not Blackrock et al.  They don’t own ETF shares.  They own collateral. Washed of taxes through processes such as what Bloomberg describes.

Bloomberg acknowledges that the same event – washing capital gains – occurs through the process of creating and redeeming ETF shares in ordinary course. Vanguard says in its ETF FAQs: “Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

That by the way can hit a stock, undermining great fundamentals.

Creations and redemptions are huge. We had an estimated $1 trillion of ETF “gross issuance,” it’s called, in the time ordinary investors yanked $6 billion from stocks.

Might that $1 trillion have SOMETHING to do with how the stock market has behaved?  Read anything about it?

I’ll give you an example of the impact: the April Fools Day’s stock tirade. Brokers knew ETFs were undercollateralized. That is, if ETFs are supposed to, say, hold 500 S&P components in proportion as collateral, the rate of increase of markets in Q1 has meant they’re sampling only – using a handful of the same liquid stocks repeatedly to create and redeem ETF shares.

But they have to square books sometime. Usually month-ends, quarter-ends.

Fast Traders tipped us to it last week by buying and covering shorts.  So the market surged not on investors buying economic news but on ETF bookkeeping, in effect.

What has not happened yet is washing out capital gains. We saw smatterings only at March options-expirations. That shoe awaits, and ETF horizons in the wholesale market where shares are created and redeemed – again, $1 trillion in Q1 2019 – are fleeting.

These facts – not suppositions – matter because financial punditry is describing the market in fundamental terms when it’s being driven by leviathan tax-avoidance and arbitrage around a multi-trillion-dollar ETF creation-redemption process.

For public companies and investors, that means it’s nearly impossible to arrive at reliably fundamental expectations for stocks.

Five Questions

Is less more?

This is the question anyone looking at the stock market as a barometer for rational thought – from stock-pickers to investor-relations professionals – should be asking.

A Wall Street Journal article yesterday, “Passive Investing Gains Even in Turbulent Times,” notes that $203 billion flowed to Exchange Traded Funds (ETFs) between September and January, while $167 billion went to index funds.

Most thought stock-pickers would win assets during volatility. So let’s ask another question. From where did the money come?  Morningstar, the WSJ says, shows $370 billion – the same figure – left stock-picking funds from Sep 2018-Jan 2019.

Here’s a third question: What sets prices for stocks?

If you move money from savings to checking, total value of your bank accounts doesn’t gyrate. Should we be asking why moving money from stock-pickers to indexers would be so violent?

I’ve got one more question for IR practitioners before we get to answers: If stock-pickers are seeing net redemptions – money leaving – what should we expect from them as price-setters in stocks?

Okay, let’s review and answer:

Is less stock-picking worth more?  What sets stock-prices? Where did the money going to ETFs and indexes come from? Why did the market move violently these last months? And finally, what should we expect from stock-pickers as price-setters?

Less is not more.  I’m reminded of a line from a professional poker-player who taught poker to a group of us.  He said, “People who chase straights and flushes borrow money to go home on buses.”

The point is that hoping something will happen isn’t a strategy. Hoping stock-pickers, which have lost trillions to passive investments over the past decade, will set your price more is chasing a flush.

We teach our clients to cultivate a diverse palette of those shrinking Active Investment relationships so an Active force will be present more frequently. We show them how to use data to better match product to consumer, further improving the odds.

But look, IR people: If stock pickers saw $370 billion of outflows, they were selling stocks, not buying them. Less is not more.

Stock prices are set by the best bid to buy or offer to sell. Not your fundamentals, or news or blah, blah, blah. What MOTIVATES somebody to hit the bid or the offer is most often that the price changed.

The investment category benefiting most from changing prices is ETFs, because they depend on an “arbitrage mechanism,” or different prices for the same thing.

(Editorial Note:  I’ll be speaking to the Pittsburgh NIRI chapter the evening of Mar 26 on how ETFs affect stocks.)

ETFs are not pooled investments. Blackrock does not combine funds from investors to buy stocks and hold them in an ETF.  ETFs don’t manage other people’s money.

ETF sponsors receive stocks from a broker as collateral, and the broker creates and sells ETF shares. Only the broker has customer accounts. The ETF’s motivation is to profit on the collateral by washing out its capital gains, leveraging it, selling it, investing it.

I’m trying to help you see the motivation in the market. The longer we persist in thinking things about the market that aren’t buttressed by the data, the greater the future risk of the unexpected.

The money that motivated ETFs to profit from changing prices September to January came from stock-pickers.

The market was violent because ETFs form a layer of derivatives in markets obscuring the real supply and demand of stocks. As stocks declined, the number of shares of ETFs did not – causing a downward cascade.

Then as money shifted out of stocks to ETFs, the supply again did not increase, so more money chased the same goods – and ETFs were a currency reflating underlying assets.

If no money either came into or left the market, and it was tumultuously up and down, we can conclude that the actual withdrawal of money from equities could be epic straight-chasing, everybody borrowing money to go home on buses.

We should expect stock-pickers to drive the market to the degree that they are price-setters. That’s 10-15% of the time. In this market riven with collateralized derivatives, you must know what sets prices.

Stock-pickers, if you know, you won’t chase straights and flushes. IR professionals, you’ll help your board and executive team understand the core drivers behind equity value. It’s your story only sometimes. They should know when it is – and when it’s not.

Much of the time, it’s just because your price changes (which ETFs feed). Ask us! We’ll show you the data behind price and volume.

FX Effects

It’s all about the Benjamins, baby.

What I mean is, Forex (FX) is the world’s most active trading market, with some $5 trillion daily in currencies changing hands on a decentralized global data network.  It can teach us how to think about the effects of Exchange-Traded Funds (ETFs) on stocks.

It’s a 24-hour-a-day market, is FX. And by the way, I’m moderating a panel called “24 Hours of Trading: What You Should Know About Market Structure” Friday at the NIRI Silicon Valley Spring Seminar.

We’re the closing panel, and happy hour follows, so come learn from our outstanding guests and stay for a beverage.  Every investor-relations professional should know how the stock market works now, because the reason we have jobs is the stock market.

Back to our thesis, ETFs trade like currencies. So they’ll have the motivation found in currency-trading.

Currencies trade in pairs, like the dollar/euro, and transactions are in large defined blocks. Most FX trades are bets that a currency will move up or down, producing a profit.  It’s always a pair – if you’re selling a currency, you’re buying another.

The transactions that create ETFs are also in blocks, though they occur off the stock market between ETF creators and broker-dealers. If you want to know more, read this.

The pair in ETF trading is stocks. In fact, ETFs by rule must have what the SEC terms an “arbitrage mechanism.” That’s esoterica meaning there are two markets for ETFs, fostering different prices for the same thing.  ETFs are created wholesale off-market in big blocks and sold retail on the market in small pieces.

The big profit opportunity, though, as with currencies, is in the pair, the underlying stocks. They move apart, creating profit opportunities. Last week, the average spread between the stocks comprising a sector and the ETF for trading that sector was 57 basis points (we wrote about these spreads).

No wonder ETFs are cheap for investors. You can make as much trading them in a week as Active investment managers charge for managing portfolios for a year (SEC: why do ETFs charge a management fee at all, since they don’t manage customer money?).

Let me use an analogy. Picture a gold-backed currency. There’s a pile of gold. There’s a pile of money representing the gold. To have more money, there must be more gold.

Of course, all gold-backed currencies have dropped the gold, because the pile of gold, which is hard to get, fails to pace the easy creation of paper.

ETFs are stock-backed currencies. There are piles of stocks off the market. There are piles of ETF shares issued into the stock market that represent the value of stocks.

Managing collateral isn’t really investment. The head of equities for a big global asset manager told me they’d gotten into ETFs because of a decade-long rout of assets from stock-picking funds.

He said it’s a completely different endeavor. There are no customer accounts to maintain.  The focus is tax-efficiency, managing collateral, constructing the basket, relationships with Authorized Participants who create ETF shares.

He said, “And then what do you need IR (investor relations) for?” They’re not picking investments. They’re efficiently managing the gold backing the currency.

Nasdaq CEO Adena Friedman told CNBC’s Squawk Box Monday, marking the 20th anniversary of the QQQ, “If there’s too much index investing and not enough individual investing, then there become arbitrage opportunities.”

She meant “arbitrage opportunity” not as a good thing but as a consequence of too much passive money.  The focus of the market shifts to spreads and away from fundamentals. The QQQ is a big success. But ETFs have now exploded.

Much of the volume in ETFs is arbitrage, because the arbitrage mechanism is the only way they can be priced – exactly like currencies now.

Investors and public companies act and think and speak as though fundamentals and economic facts are driving the market. The more the market shifts toward collateral and currency, the less fundamentals play a pricing role.  This is how ETFs are giving stocks characteristics of an FX market where the motivation is profit on short-term spreads.

Like currencies, changes in supplies are inflationary or deflationary. Consider how hard it is for countries to reduce supplies of currency.  Whenever they try, prices fall. Falling prices produce recessions. So instead countries don’t shrink currency supplies and we have catastrophic economic crises.

Are ETF shares keeping pace with the assets backing them? It’s a question we should answer. And IR folks, your relevance in this market is as chief intelligence officer measuring all the forces behind equity value. You can’t remain just the storyteller.

Manufactured Spreads

Did Exchange Traded Funds drive the recent market rollercoaster?

The supply of ETF shares moved opposite the market. The S&P 500 fell about 16% in December and rose around 19% from Dec 24 to March 5.  In December, says the Investment Company Institute, US ETFs created, or introduced, $260 billion of ETF shares, and redeemed, or retired, $211 billion.

So as the market tumbled, the number of ETF shares increased by $49 billion.

We saw the reverse in January as the market soared, with $208 billion of ETF shares created, $212 billion redeemed, the supply shrinking a little.

If ETFs track indexes, shouldn’t available shares shrink when the market declines and increase when the market rises?  Why did it instead do the opposite?

One might point to the $46 billion investors poured into equity ETFs in December at the same time they were yanking $32 billion from Active funds, says Morningstar.

Again a contradiction. If more money flowed to equities than left, why did the S&P 500 fall?  Don’t stocks rise when there are more buyers than sellers, and vice versa?

The fact that data and market behavior are at loggerheads should cause consternation for both investors and public companies. It means we don’t understand supply and demand.

One explanation, the folks from the ETF business say, is that inflows to ETFs may have been short. That is, when ETF shares increase while stocks are falling, ETF creators are borrowing stocks and trading them to Blackrock and Vanguard to create ETF shares for investors, who borrow and sell them.

These people explain it in a tone of voice that sounds like “aren’t we geniuses?”

But if true, the unique characteristics of ETFs that permit them limitless supply and demand elasticity contributed to the market correction.

We cannot manufacture shares of GE to short.  But ETF market-makers can manufacture ETF shares to short. How is that helpful to long-only investors and public companies?  The behavior of stocks separates from fundamentals purely on arbitrage then.

Here’s another statistical oddity: The net shrinkage in January this year marks only the third time since the 2008 Financial Crisis that the monthly spread between ETF creations and redemptions was negative. The other two times were in February and June last year, periods of market tumult.

And still the ETF supply is $45 billion larger than it was when the market corrected (near $55 billion if one adds back market-appreciation).

We conducted an experiment, tracking week-over-week gains and losses for stocks comprising the eleven General Industry Classification System (GICS) sectors and comparing changes to gains and losses for corresponding sector ETFs from State Street, called SPDRs (pronounced “spiders”) from Dec 14 to present.

Startlingly, when we added up the nominal spread – the real difference between composite stocks and ETFs rolled up across all eleven sectors – it was 18%, almost exactly the amount the market has risen.

What’s more, on a percentage basis the spreads were not a penny like you see between typical best bids to buy and offers to sell for stocks. They averaged 5% — 500 basis points – every week.  The widest spread, 2,000 basis points, came in late December as stocks roared.

Now the spread has shrunk to 150 basis points and markets have stopped rallying.  Might it be that big spreads cause traders to chase markets up and down, and small spreads prompt them to quit?

Now, maybe a half-dozen correlated data points are purely coincidental. False correlations as the statistics crowd likes to say.

What if they’re not?  Tell me what fundamental data explains the market’s plunge and recovery, both breath-taking and gravity-defying in their garishness? The economic data are fine. It was the market that wasn’t. What if it was ETF market-making?

The mere possibility that chasing spreads might have destroyed vast sums of wealth and magically remanufactured it by toying with the supply of ETF shares and spreads versus stocks should give everyone pause.

Investors, you should start thinking about these market-structure factors as you wax and wane your exposure to equities.  If fundamentals are not setting prices, find the data most correlated to why prices change, and use it.  We think it’s market structure. Data abound.

And public companies, boards and executives need a baseline grasp on the wholesale and retail markets for ETFs, the vast scope of the money behind it — $4.5 TRILLION in 2018, or more than ten times flows to passive investors last year – and what “arbitrage mechanism” means. So we’re not fooled again (as The Who would say).

What do data say comes next?  Sentiment data are the weakest since January 7 – and still positive, or above 5.0 on our ten-point Sentiment scale. That’s a record since we’ve been tracking it.

So. The market likely stops rising.  No doom. But doom may be forming in the far distance.