Tagged: ETFs

Half the Market

I’ve seen at least four Wall Street Journal stories in May alone about a quiescent VIX.

The CBOE’s volatility index derived from options pricing on the S&P 500 hit a low Monday last seen in Dec 1993, the WSJ said (subscription required). It moved lower still yesterday, 9.58 intraday.

Implicit in the storyline is a bull market, since one roared from 1993 to the bursting of the dot-com bubble. But the conclusion violates the Law of Small Numbers, the human propensity to assign undue value to insignificant data sets.  As proof, the VIX was a hair’s breadth from record low in Jan 2007.

Remember that? Lehman, little did we know, was failing. The financial crisis thereafter manifested in markets like a Hollywood blockbuster action movie where the hero outruns the explosion as the structure dissolves in showering computer-generated fantasia.

Since we can make equal bull or bear cases with the same data, it supports neither.

Aside: The investor-relations profession has a notorious proclivity toward the Law of Small Numbers. Stock’s down 3%, so we call somebody to learn why. You’re chasing the exception. Track instead the central tendency in the whole data set so you can see what changed before the stock fell 3%.

And assigning rational motivation to the VIX defies the data.  Less than 20% of daily market volume comes from rational thought. The rest is tracking the mean, arbitraging spreads back to the mean, or hedging departures from the mean.

Where everything is average, volatility vanishes. Thus a dead VIX fits. It offers little predictive value (save higher volatility always follows very low) and simply points to low spreads.

The reason is market structure. Passive investment tracks benchmarks and so seeks the mean – average price. Arbitragers look for departures from the mean to trade for profit. The market is riven with arbitrage so few mean-divergences survive to the close. But boy is there opportunity. You’ll see soon.

Meanwhile, those managing risk offload exposure to someone else, which produces equal and offsetting trading – which reinforces the mean.

And here’s a shocker. We track daily share-borrowing – shorting – as a percentage of total trading volume. Short shares are 48.1% of volume, which means long trades are 51.9%. In other words, nearly half the market is short.

Locked markets, or trades where the bid to buy equals the asking price to sell, are prohibited, so there will always be a spread, a dab of volatility. Arbitragers are almost guaranteed gains by being long and short everywhere.

We also measure intraday volatility, the spread between average intraday high and low prices. It’s 2.5% – astonishing arbitrage fodder.

For perspective, the S&P 500 rose 0.5% the last ten sessions. That means stocks are 400% more volatile every day than the ten-day change in closing prices.

Arbitragers are making tremendous gains by consuming intraday volatility.

It may be that Exchange-Traded Fund (ETF) market-makers are responsible. It explains why ETF costs are so low: Arbitrage gains are additive.

And ETF sponsors can rent out liquidity, shares accounting for the 48% of trading that’s borrowed – boosting returns. There’s support in the data. We track passive-investment patterns and correlate them to short volume, and there’s agreement.

ETF market-makers have four arbitrage opportunities: a) ETF net asset value versus ETF price; b) ETF versus underlying index; c) ETF price versus prices of components of the index; d) ETF price versus options and futures on components and the index.

By the close, ETFs and indexes want to peg the measure so divergences converge at average.

It’s a circumstantial case. But evidence piles up that ETFs are consuming spreads while simultaneously driving stock-prices and deflating the VIX.

What’s the risk?  Mortgage-backed securities did the same thing to real estate.  There was a finite asset, homes. With cheap mortgages, lots of money wanted exposure. So home loans were securitized – replicated – to expand demand, delivering great returns to those selling them. It worked till home prices stopped rising. Then replicated value evaporated. Half the market.

There are less than 3,600 US public companies when ETFs, multiple share classes and closed-end funds are removed. Low rates have created high demand. To expand access, ETFs replicate exposure, and are booming. It works so long as stocks rise.

When that stops at some sure point, extrapolated value will be marked to zero. Half the market.  Won’t arbitragers save the day? Not if volatility jumps as average prices plunge.

Blackrobotics

The point isn’t that Blackrock picked robots over humans.  The point comes later. 

If you missed the news, last week the Wall Street Journal’s Sarah Krouse reported that Blackrock will revamp its $275 billion business for selecting individual stocks, turning over most decisions to machines (ejecting scores of human managers).

For perspective, that’s about 5% of Blackrock’s $5.1 trillion in assets. The other 95% is quantitative already, relying on models that group stocks around characteristics ranging from market capitalization to volatility.

Spanning 330 Blackrock iShares Exchange-Traded Funds (ETFs) are 14 primary clusters of characteristics that define investments. What Blackrock calls its “core” set are 25 ETFs managing $317 billion, more than the entirety of its active stock-picking business. Core investment describes what Blackrock sees as essentials for a diversified portfolio.

Blackrock views investing as a mixture of ingredients, a recipe of stocks.  The world’s largest asset manager thinks it’s better at crafting recipes than picking this or that flavor, like Fidelity has done for decades. 

But who is most affected by the rise of Blackrobotics?  We come to the point.  Two major market constituencies are either marginalized or reshaped: Public companies and sellside stock researchers.

“Sellside” means it’s the part of the market selling securities rather than buying them. Blackrock is on the buyside – investors who put money into stocks. The sellside has always helped investors by keeping stocks on hand like Merrill Lynch and Morgan Stanley used to do, and processing stock trades.

The sellside since brokers first fashioned the New York Stock Exchange also armed investors with valuable information through stock analysis. Analysts were once the big stars wielding power via savvy perspectives on businesses and industries. Everybody wanted to be Henry Blodget talking up internet stocks on CNBC.

Following the implosion of the dot-com boom of the 90s, regulators blamed stock analysts and enforced a ban on the use of valuable research preferentially, a mainstay for brokers back two centuries. So the sellside shifted to investing in technology rather than people, and the use of trading algorithms exploded.

Brokers – Raymond James to Credit Suisse, Stifel to JP Morgan – have long had a symbiotic relationship with public companies. Brokers underwrite stock offerings, placing them with their clients, the big investors.  After initial public offerings, analysts track the evolution of these businesses by writing research and issuing stock ratings. 

That’s Wall Street.  It reflects the best symbiosis of creative energy and capital the world has ever seen. Analysts issue ratings on stocks, and companies craft earnings calls and press releases every quarter, and money buys this combination. The energy of it hisses through the pipes and plumbing of the stock market. 

Blackrock uses none of it. It’s not tuning to calls or consuming bank research. Neither does Vanguard. Or State Street. Together these firms command some $11.5 trillion of assets eschewing the orthodoxy of Wall Street.

Public companies spend hundreds of millions annually on a vast array of efforts aimed at informing stock analysts and the investors who follow what they say and write. Earnings calls and webcasts, websites for investors, news via wire services, continuous travel to visit investors and analysts.

It’s the heart of what we call investor relations.

What Blackrobotics – Blackrock’s machines – mean to public companies is that some effort and spending are misaligned with the form and function of the market. It’s time to adapt. The job changed the moment Vanguard launched the first index fund in 1975.  You just didn’t know it until now. 

How do I change it, you ask? You can’t. Public companies should expend effort proportionate with the behavior of money. The trillions not tuning to calls or reading brokerage research deserve attention but not a message.

If money is using a recipe, track the ingredients and how they affect valuation, and report on it regularly to management. Get ahead of it before management asks.

It’s neither hard nor scary. What made index investing a great idea, to paraphrase Vanguard founder Jack Bogle, was that it was difficult for investors to be disappointed in it.  Same applies to IR and passive investing. What makes data analysis alluring is that it’s a management function and it’s hard to be disappointed in it.

(Note: If you want help, ask us. We use machines to measure machines and it’s simple and powerful and puts IR in charge of a market run by them. I talked about it yesterday at the NIRI Capital Area chapter).  

I’m not sure how capital forms in this environment. Wall Street lacks plumbing. Thus, companies grow privately and become index investments via IPOs, exiting as giants that are instantly part of the thousand biggest in which all the money concentrates.  

It’s not the end of the world, this rise of the machines.  But Blackrobotics come at a cost.  We all must adapt. It’s far less stressful embracing the future than missing the past.

Market Serfdom

Last week a stock strategist said passive investment is worse than Marxism.

That’s a way to get attention at risk of offending Marxists. It did (get attention). CNBC covered it. Jason Zweig did too in the Wall Street Journal weekend edition.

It’s relevant to investor relations because passive investment is sweeping the planet. We call it “the elephant in the room” because public companies sometimes seem paralyzed as mass capital inured to the sellside and results and road shows floods stocks.

The shift is huge. Mr. Zweig noted that in the past year $300 billion left active stock-picking portfolios as $400 billion flowed to indexes and exchange-traded funds.  Over the trailing decade, data from the Investment Company Institute show it’s trillion of dollars routing from active funds to passive vehicles.

You’ve seen the Betterment ads?  This “robo advisor” let’s investors precisely tailor exposure to various assets the same way architects use CAD systems to design structures.

At Sanford Bernstein in London, senior analyst Inigo Fraser-Jenkins released a report borrowing economist Friedrich Hayek’s phrasing called “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” I thought immediately of “The Princess Bride” as I’d never encountered anyone named Inigo save Montoya (Mandy Patinkin) in that film pursuing the six-fingered man.

Mr. Fraser-Jenkins, erstwhile head of quantitative strategy at Nomura, thinks the six-fingered threat from passive investment is its lack of judgment for committing capital.

Brilliant point. The equity capital market formed so people with money could take risks on businesses that might improve the human lot.  The brokers pooling capital then supported these endeavors with research so investors could make informed decisions.

Enter Blackrock and Vanguard. No, they’re not Trotsky and Lenin papered in currency. But they’re massive through efficiency, market rules, monetary policy (a system, not good judgment, makes it work), not prowess or wisdom.

Mr. Zweig says Vanguard reported owning 6% of all US shares. Assume Blackrock is about 7%. Combined, they’re 10-15% holders of everything. Dictators.

“What happens when everybody indexes?” John Bogle, Vanguard founder, said to Mr. Zweig.  “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.”

Mr. Bogle adds that we’re a long way from there.  Indexes would have to grow to 90% of the market from between 5-10% now. Oh? We’ll come back to this point to conclude.

When money is directed by a model to equities, there’s a shift in purpose from giving to taking.  How? Models take a piece. Investors commit.

The market first formed so entrepreneurs needing risk-taking capital could find it. A market priced around the willingness of investors to accept risks combined with the capacity of businesses to deliver results is the heartbeat of efficient capital-allocation.

Models don’t care about that relationship. They take, then leave. So invention happens on private equity, which removes from the American capital model its defining egalitarianism for the masses and instead concentrates it in ever fewer hands.

Your job just took on added importance, IR pros. You alone can track the impact and evolution of asset-allocation. Move beyond telling the story to measuring quantitative investment. It’s the job of IR to apprise executives and boards of important facts about the equity market.  It’s our market. No index will tell you something is amiss.

So The Elephant slouches toward serfdom.

In that shadow, any company considering itself a yield investment has Big Data looming tomorrow after the close. Most REITS will separate into a new industry classification from Financials.  That’s like a massive index-rebalance playing out over coming weeks.

Concluding, Mr. Bogle is wrong about how much bigger indexing can get before markets are paralyzed.  We’re now pushing limits. Indexes and ETFS are currently 32-33% of daily volume, combined (our measures). At 40% there will be no room for anything but machines. Stocks are needed to satisfy stock-pickers, fast traders, counterparties for derivatives and trading leverage. It’s already so finely balanced that most stocks don’t trade more than 200 shares at once.

You’re the frontline, IR. This is your fight. Report on it (we can help). Solution? Remove rules making averages the goal. Stock-picking would soar anew.  Else? Serfdom.

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?

Correlating Volatility

“Measure the performance of equity securities in the top 85% by market capitalization of equity securities listed on stock exchanges in the United States.”

I made it a sentence here but I clipped that phrase from a Blackrock iShares “minimum volatility” Smart Beta Exchange Traded Fund (ETF) prospectus and Googled it, and got back pages of references.  Apparently many indexes and ETFs meant to diversify and differentiate investments are built on the “top 85% by market capitalization.”

That by the way is about 700 companies. There are now over 700 ETFs in the US stock market and about 3,700 total public companies when you strip out funds and multiple classes of stock.  That’s a 1-to-5 ratio.  If many ETFs track indexes comprised of just 20% of the stocks, would that not produce high correlation?

Answer:  Yes.

I ran correlation for five ETFs from Blackrock, First Trust, Schwab, Vanguard and Invesco (USMV, FVD, SCHD, VIG, SPLV) over the past three months and it was about 90%.  Now, all five seek similar objectives so correlation isn’t surprising. But in truth they’re brewing a mixture of the same stocks.

We had the chance to participate in a wine-blending last month in Napa. The group was tasting mixtures of a core set of grapes.  What if we make it 94% Zinfandel, 3% Petit Syrah and 3% Malbec?  How about 7% Malbec, 3% Petit Syrah, 90% Zinfandel?

The same thing is happening with ETFs. They’re blending the same grapes – stocks.  What if we weight a little more than the index in WMT and a little less in AMZN?

It’s still the same stocks. And it’s earnings season.  Think about the impact of high correlation when in nearly all cases save an outlier handful ETFs track underlying indexes with defined composition.

Say you report results and your stock plunges (we’ll come to why in a moment). Even minute weighting in a falling stock can skew the ETF away from the benchmark, so the authorized participants for the ETF sell and short your shares, raising cash to true up net asset values and ridding the ETF of the offending drag.

At some future point now that your shares are sharply discounted to the group and the market, arbitragers will find you and the authorized participants (brokers creating and redeeming ETF shares to ensure that it tracks its benchmark as money flows into and out of the investment vehicle) who shorted will cover, and suddenly you’re the star again.

Neither up nor down did the behavior of your stock reflect fundamental value or rational thought. It’s high correlation, which rather ironically fosters mounting volatility. We’re seeing a notable increase in instances of large moves with earnings.  And your shares don’t drop 15% because active investors saw your numbers and decided, “Let’s destroy our portfolio returns by buying high and selling low.”

In the last week through Monday, Asset Allocators (indexes and ETFs) and Fast Traders (arbitragers speculating on intraday price-changes) were top price-setters.  Both are quantitative, or machine-driven, behaviors. One is deploying money following a model and the other is betting with models on divergences that will develop during that process.

Both create mass volatility around surprises in earnings reports. Fast Traders are the athletes of the stock market racing to the front of the line to buy and sell. Asset Allocators are lumbering, oblivious to fundamental factors and instead following a recipe.

You report.  Active investors stop their bits and pieces of buying or selling to assess your fundamentals. Sensing slight change, Fast Traders vanish from order books across the interconnected web comprising today’s stock market.  Asset Allocators tracking benchmarks stop buying your shares because you’ve now diverged from the broad measure.

This combination creates a vacuum.  Imagine selling your house and there was a bidding war for it and suddenly all the bidders disappeared. You’d have to cut your price. What changed?  The number of potential buyers, not the value of the house.

This is the problem with how a combination of Fast Traders and Asset Allocators dominate the market now.  Fast Traders set most of the prices but want to own nothing so the demand they create is unreliable and unstable.  Asset Allocators are trying to track benchmarks – that depend on Fast Traders for prices. Throw a wrench into those delicate gears with, say, a surprise in your quarterly earnings, and something will go awry.

Speaking of which, our Sentiment Index just turned Negative for the first time since February and yet the market soared yesterday.  From Feb 8-11, futures contracts behind some of the most actively traded ETFs in the market, concentrated in energy, rolled. The dollar had just weakened. Stocks roared.

The same futures contracts just rolled and the ETFs rebalanced (May 6-11). Counterparties covered. The dollar is rising. We may be at a tipping point again for stocks. Derivatives now price the underlying assets.

False Passive

Karen and I are in Boston seeing friends at the NIRI chapter (we sponsor) and our trip today like last week coincides with snow in Denver. Next winter if the slopes turn bare, we’ll schedule a couple flights to bring in the blizzards.

Last week trooping through Chicago where you had to lean to stay upright in the wind, an investor-relations officer told me, “Passive money can’t be setting prices because it’s, well, passive. It can only follow active money.”

Sometimes I’m so close to the trees of market structure that I forget about the forest everyone else is seeing. Statisticians warn about false positives, false correlations, false precision. The descriptor “passive” for investment behavior following models inaccurately portrays what the money is doing. We call it “Asset Allocation” behavior.

To understand this money let’s first review how the stock market works:

It’s a data network comprised of visible nodes called exchanges and invisible ones called formally alternative trading systems and colloquially “dark pools,” stores for stocks where you must be a member to buy. Exchanges are required to serve all customers, who must either be a broker or use one.

All markets share customers and prices. You cannot continue to serve a customer in one market including a dark pool at a price worse than what’s available elsewhere. Thus, trades must match between the network-wide best price called the NBBO – national best bid/offer (best price to buy or sell).

Orders wanting to price the market must be automated so they can rapidly move from one node to the next, or the data network can’t function.

-Because of this structure, exchanges offer trading incentives called “rebates” to more frequently have the best price on the network. They pay high-speed traders about $0.29/100 shares to bring orders to their markets and set prices.

-The NYSE, the Nasdaq and BATS Global Markets operate multiple exchanges, rather than one that would aggregate buying and selling, so as to increase the amount of time each group has the best price, which means fast traders create many prices. By our measures, fast traders are eight times as likely to set prices, but with just 100 shares.

Exchanges want to set prices because any broker or market center handling customer orders must give customers the best prices so all are required to buy expensive pricing data, which is how exchanges make money.

Now you understand the stock market. Onto this network come seas of money from Blackrock and Vanguard and a raft of exchange-traded funds. For two decades investors have been choosing passive investment in accelerating fashion. It’s how Blackrock and Vanguard are the world’s biggest investors ($8 trillion of assets) and ETFs host $3 trillion while turning holdings at 2,500% (making buy-and-hold a parody).

Passive money is governed by the model it tracks, the prospectus describing the fund, and inflows and outflows. Tack on the explosive popularity in recent years of “smart beta” money tracking mathematical measures to capitalize on trends or market inefficiencies and you have a recipe for perpetual motion.

To that end, indexed money by rule must peg its benchmark – the measure metering its performance. Indexes use options and futures to mirror the benchmark so counterparties for options and futures are in and out of the market. That sets prices.

The majority of trading in ETFs is a form of arbitrage. ETFs don’t buy or sell stocks. ETF sponsors privately transact with authorized participants in large blocks. In the market, people are trading ETF shares that simply represent assets held by sponsors. Market-makers are shorting or going long components to capture inefficiencies, and fast traders are repricing components, indexes, options and futures for spreads.

All of this is setting your price. If money flows into SPY, the world’s most actively traded stock with $25 billion of volume daily, arbitragers, market-makers and authorized participants must respond. This trade splashing through your peer group may move members disparately at times because of liquidity, options, futures, shorting.

A paradoxical cycle forms. Indices fluctuate because of arbitrage in ETFs predicated on them, which prompts indexed money to adjust, which must happen because rules for indexes demand it.

The sheer size of this money has pervasive market impact, often blotting out effort by active investors to buy or sell growth and value opportunities (uniform rules and uniform trade-executions overwhelm outlier orders, key to why stock pickers rarely beat indexes).

There’s little that’s passive about passive investment. Call it Asset Allocation. But it lacks emotion, reason and common sense. That’s why markets are unresponsive to terror attacks or flagging economies but wedded to monetary policy. It’s about the model.

Culmination

Outcomes are culminations, not events.

Denver bid farewell this week to retiring Broncos quarterback Peyton Manning who for eighteen years accumulated the byproducts of focus, discipline and work, twice culminating in Super Bowl victories.

The idea that outcomes are culminations translates to the stock market. What happens today in your stock-trading is a product of things preceding today’s culmination just as our lives are accumulations of decisions and consequences.

Rewind to Feb 11, 2016. The S&P 500 hit a 52-week low of 1829. Recession fears were rippling globally. European banks were imploding, with some pundits predicting another 2008 crisis. China was lowering growth views and weakening its currency to pad the landing (word since is some 5-6 million workers will be laid off through 2017).

In apparent response, the US stock market soared, recovering to November levels. If the market is a proxy for the economy, it’s a heckler hurling eggs. Wiping away yolk, pundits said markets expecting monetary tightening from the Federal Reserve saw stasis instead. Recession fears were overblown and an overly reactive market rebounded.

But headlines don’t buy or sell stocks, people and machines do.  Markets move on money. This is what we’ve learned from more than a decade of market lab work, repeating behavioral measurements with software, servers, algorithms and models.

Follow the money.  The most widely traded equity in the world, SPY, is a derivative. It’s an Exchange-Traded Fund (ETF) tracking the S&P 500.  Nearly 50% of all options volume ties to it.  In 2016 so far almost every trading day at least 12 of the 25 most actively traded stocks were ETFs.

Why do we say ETFs are derivatives? Because derivatives extend access to assets, exactly the thing ETFs do. They’re securities trading on underlying stocks without owning them. The sponsor owns assets, yes. But ETF investors hold only a proxy.

ETFs depend on arbitrage. Rules the SEC approved for ETFs effectively sanction use of information the rest of the market doesn’t know about demand by the big brokers who produce ETF shares for trading.  These brokers are continually shorting index components and derivatives or ETF shares to close the gaps that form between the value of the ETF and what it represents (stocks, sectors, commodities, bonds, indices).

In the stock market, the price-setters are primarily short-term traders (high-frequency firms) arbitraging small price-divergences in many things simultaneously. ETFs are stocks that provide exposure to other stocks, sectors, commodities, bonds and indices. For arbitragers, they’re a massive additional layer of arbitrage permutations:  How might this financial ETF vary with that energy futures contract, and this basket of energy stocks?

What develops in this market is a disregard for fundamental factors. Prices are mathematical facts. Spreads drive directional-change. The market’s purpose devolves from economics to how to price a stock, sector, commodity, bond, futures contract, option or index relative to things associated with it or its value at a point ranging from fractions of seconds to next month before a derivatives contract expires.

It’s not investment but arbitrage of such scale and size that few recognize it. Yesterday, the most actively traded stock was the VelocityShares 3x Long Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return (UWTI).  Yes, that its name! It’s an exchange-traded product backed by Goldman Sachs, and it dropped 13.3%. Offsetting, the eighth most active stock was DUST, the Direxion Daily Gold Miners Index Bear 3x Shares, which rose 13.7%.

Neither DUST nor UWTI owns tangible assets. Their returns depend on derivative contracts held by banks or other counterparties. Now step back. Look at stocks. They are moving the same way but over longer periods. Market moves are a culmination of whichever directional trade is winning at the moment, plus all the tiny little arbitrage trades over ETFs, stocks, commodities, bonds and indices, tallied up.

There are two links back to fundamentals. First, banks back this market. Some of them are losing badly and this is what European bank trouble last month signaled. And this IS a consequence of Fed policy.  By artificially manipulating the cost of capital, the Fed shifted money from scrutinizing economics to chasing arbitrage opportunities.

When arbitrage has exhausted returns, the market will change direction again. It’s coming soon.  The bad news is the market has not yet considered economic threats and is ill-equipped to do so.

Inconvenience

Follow the money. Or the currency.

Yesterday markets soared on queue with a Chinese currency devaluation in the form of lower bank reserve requirements (which increases money and reduces its value). For those who at the words “currency devaluation” feel like collapsing into catatonia, resist the urge. There’s a lesson ahead.

WSJ Intelligent Investor columnist Jason Zweig described Feb 19 how active investors are using Exchange Traded Funds (ETFs). He wrote, “Picking stocks has become so hard that some stock pickers have given up pretending to try.”  One manager told Mr. Zweig he keeps 50% of his assets in ETFs because with 90% of active money trailing the averages, “half of my fund will beat 90% of managers over time.” The winning half is polling the crowd.  It’s more convenient.

The crowd today is comprised of leviathan passive investment typified by the $8 trillion held at Blackrock and Vanguard.  But that’s not what moves daily.  It’s inconvenient for Blackrock and Vanguard to maneuver massive assets like a race car through less than ten big banks executing most trades now for large institutional investors.

But investing is supposed to be inconvenient. Value that lasts should take time. Warren Buffett is 85 and began investing in his teens.  The average holding period for Berkshire Hathaway shareowners is 27 years based on annual turnover. Rome wasn’t built in a day.

Yet today’s market sells convenience. Leveraged ETFs – those using derivatives like swaps to outperform underlying benchmarks – seek one-day outperformance. From Direxion, a sponsor: “The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that may cause their price to fluctuate over time. The funds do not attempt to, and should not be expected to, provide returns which are a multiple of the return of the Index for periods other than a single day.”

In yesterday’s big market move, over half of the 25 most actively traded securities were ETFs, most of them trading more than stocks like Pfizer and GE.  Several were 3x leveraged ETFs – that is, trades designed for a single day to beat a broad measure by 200%. If your stock was up twice as much as the market, there’s your probable answer.

ETF sponsors hold assets, and big brokers called Authorized Participants create ETF shares for trading or remove them from the market to match inflows and outflows and fluctuations in underlying stocks and indices. That’s a derivative. What’s traded isn’t the asset but a proxy. A key reason why stock pickers struggle is because long-term investments are inconvenient, and the many parties in the market chasing one-day moves or short-term divergences drown out fundamental differences in businesses.

There’s a triune reason for volatility that’s getting bigger, not smaller.  First, the whale in the market is money tracking benchmarks like the S&P 500. Clustered next around the benchmarks are options and futures and ETFs. The ETF SPY yesterday traded nearly ten times the dollar-amount ($26.3 billion) of the nearest active stock (VRX, $2.7 billion). And last, every ETF has what’s in effect counterparties –authorized participants maintaining coherence between ETFs and indexes (to us it’s sanctioned arbitrage since the APs know which direction money is moving and can go long or short advantageously, which is ethically questionable). So also do counterparties back the options, futures and swaps fueling leveraged ETFs and trading schemes and index-tracking by big funds.

Line these up.  Money is tracking indexes. Leveraged ETFs are trying to beat them. Counterparties are supplying options and futures to achieve those returns. Every day it changes and the movements are like a freight train on a twisting track, picking up speed, as each gets a day or two out of step with the others.

At what point does it rupture? Making homes too easy to buy through loose credit led to mushrooming mortgage-backed derivatives and later mass demise. Making money too easy for governments to get through central banks is behind the creaking mountain of global debt that the private sector long ago largely stopped buying (so it’s instead held by central banks that pledged the full faith and credit of the same citizens refusing to buy in private markets).

We’d benefit from old-fashioned inconvenience. Investments taking more than a day to produce a return. What’s valuable – time, money, risk, production, thrift, prudence, diligence – shouldn’t be marginalized into a derivatives trade.  Alas, we humans seem to recognize mistakes only in hindsight.

Side Deals

Yesterday on what we call Counterparty Tuesday, stocks plunged.

Every month options, futures and swaps expire and these instruments represent trillions of notional-value dollars. Using an analogy, suppose you had to renew your homeowners insurance each month because the value of your house fluctuated continually.  Say there’s a secondary market where you can trade policies till they expire. That’s like the stock market and its relationship to these hedging derivatives.

As with insurance, somebody has to supply the coverage and take the payout risk. These “insurers” are counterparties, jargon meaning “the folks on the other side of the deal.”  They’re banks like Deutsche Bank, HSBC, Morgan Stanley, Citi.

Each month the folks on the other side of the deal offer signals of demand for insurance, a leading indicator of investor-commitment. We can measure counterparty impact on market volume and prices because we have an algorithm for it.  Last week (Feb 17-19) options and futures for February expired and the folks on the other side of the deal dominated price-setting, telling us that trading in insurance, not the assets themselves, was what made the market percolate. That’s profoundly important to understand or you’ll misinterpret what the market is doing.

On Monday Feb 22, a new series of derivatives began trading. Markets jumped again. Yesterday on Counterparty Tuesday, the folks on the other side of the deal told us they overshot demand for options and futures or lost on last week’s trades.  And that’s why stocks declined.

The mechanics can be complicated but here’s a way to understand. Say in early February investors were selling stocks because the market was bearish. They also then cut insurance, for why pay to protect an asset you’re selling (yes, we see that too)?

Around Feb 11, hedge funds calculating declines in markets and the value of insurance and the distance to expirations scooped up call options and bought stocks, especially ones that had gone down, like energy and technology shares and futures.

Markets rose sharply on demand for both stocks and options. When these hedge funds had succeeded in chasing shares and futures up sharply in short order, they turned to the folks on the other side of the deal and said, “Hi. We’d like to cash these in, please.”

Unless banks are holding those stocks, they’re forced to buy in the market, which drives price even higher. Pundits say, “This rally has got legs!” But as soon as the new options and futures for March began trading Monday, hedge funds dumped shares and bought puts – and the next day the folks on the other side of the deal, who were holding the bag (so to speak), told us so. Energy stocks and futures cratered, the market swooned.

It’s a mathematical impossibility for a market to sustainably rise in which bets produce a loser for every winner. If hedge funds are wrong, they lose capacity to invest.  If it’s counterparties – the folks on the other side of the deal – the cost of insurance increases and coverage shrinks, which discourages investment.  In both cases, markets flag.

Derivatives are not side deals anymore but a dominant theme. Weekly options and futures now abound, more short-term betting. Exchange-Traded Funds (ETFs), derivatives of underlying assets, routinely populate lists of most active stocks. Both are proof that the tail is wagging the dog, and yet financial news continues casting about by the moment for rational explanations.

Every day we’re tracking price-setting data (if you don’t know what sets your price the problem is the tools you’re using, because it’s just math and rules).  Right now, it’s the counterparties. Short volume remains extreme versus long-term norms, telling us horizons are short. Active investment is down over $3 billion daily versus the long-term.

You can and should know these things. Stop doing what you’ve always done and start setting your board and your executives apart. Knowledge is power – and investor-relations has it, right at our fingertips.