EDITORIAL NOTE: We are on a big catamaran with Painkillers in hand watching the sun dissolve into an aqua Grenadine sea. So while we all float on, here’s Part Two of our return to the past to learn today’s lessons. The piece below originally ran Mar 7, 2018. If we’re going to understand today’s market, we must wrap our minds around the vastness of the ETF Effect:
I can’t find a team (men’s or women’s) headed to March Madness, the annual collegiate sports fete in the USA, wearing green and purple. But the market’s awash in them.
Don’t you mean red and green, Tim? Buy and selling?
No, green and purple. See this image? Green and purple are Passive Investment and Risk Management, a combination revealing how arbitrage in Exchange Traded Funds (ETFs) is taking over the stock market.
In the first circle, green and purple coincide with short covering (lower bar graph) and a surge in price. In the second, green and purple again, shorting up, price falls. It’s an anonymous stock exemplar but we see these patterns everywhere.
Monday, a friend sent me a note: “First thing I heard today when I got in the car to go to work and turned on the news is ‘Dow is down on fears of Trump tariff.’ Now I see the market is up 400 points. Should it say: ‘Markets up on Trump tariff?’”
Some pundits, coughing in advance, said it was reduced fears of tariffs on Canada and Mexico. It may be the green and purple gang and not rational thought at all.
I’ve written before about the “arbitrage mechanism” for ETFs. Google “ETF arbitrage mechanism.” It’s presented as a good thing – the way ETFs can closely track an index.
Yet apart from ETFs, regulators, congresspersons, pundits, investors, all rail at “the arbitragers” for distorting prices and manipulating markets. Isn’t it cognitively dissonant to say it’s good for ETFs but bad elsewhere?
If we don’t know what’s pricing the market because a pervasive “arbitrage mechanism” – green and purple going long and short – trumps Trump tariffs or any other fundamental consideration, the market cannot serve as a reliable barometer for corporate effort or economic activity. I’m surprised it’s not troubling to more.
For every trade executed in the stock market in December, 19 were cancelled before matching according to Midas data from the SEC. Of those that completed, 30% were odd lots – less than 100 shares (no wonder average trade size is about 180 shares).
Trade-cancellations in ETFs run about four times higher than in stocks, near 80-to-1, Midas shows. If trading motivation is changing the price, cancellations will run high. Investors don’t do it. Profiting on price-differences is arbitrage. Only 5% of US stock orders execute, suggesting a lot of arbitrage. It’s rampant in ETFs. Green and purple.
Here’s what I think. Brokers trade collateral like stocks and cash at a fixed, net-asset-value to ETF sponsors tax-free for ETF shares. They cover borrowed stock-shares, bet long in futures and options on the indexes and components and sell ETF shares to investors.
When the group or index or sector or market-measure has appreciated to the point the ETF sponsor will incur taxes on low-basis stocks in the collateral the brokers provided, the brokers short those stocks and the options and futures and buy the ETF shares and return them to receive the collateral back in exchange.
Headlines may create entries and exits. This process repeats relentlessly, prompting investors and pundits and companies to draw widespread false correlations between market behavior and fundamental or economic factors.
It’s a genius way for brokers, traders and fund sponsors to make money. One could say we all benefit by extension. To a point, yes. So long as more money comes into the market than leaves it, stocks rise.
Volatility mounts on over-correction, where the arbitragers cover at the wrong time, short at the wrong time or exchange collateral for ETF shares in ill-timed ways, leaving puzzled people watching the tape.
Upon reflection, I guess it’s a good thing no team is wearing green and purple. The rest of us would do well to get as good at pattern-recognition as we are at PE ratios, because the patterns are setting prices. Watch the green and purple.