CNBC’s Brian Sullivan invited me to discuss shrinking market liquidity last Friday. Riveting, huh!
Well, it is to me! Unraveling the mystery of the market has turned out to be a breathtaking quest. I had another aha! moment this weekend.
Jane Street, a big Exchange Traded Funds (ETF) Authorized Participant, commissioned a study by Risk.net on ETF liquidity. As a reminder, APs, as they’re called, are essential to the ETF supply chain. They’re independent contractors hired by ETF sponsors such as State Street to create and redeem ETF shares in exchange for collateral like stocks and cash.
Without them, ETFs can’t function. In fact, they’re the reason why ETFs have been blanket-exempted from the Investment Company Act of 1940 under SEC Rule 6c-11, recently approved.
Exempted from what? The law that all pooled investments be redeemable for a portion of the underlying assets. There is no underlying pool of assets for ETFs, as we’ve explained before.
If you’re thinking, “Oh, for Pete’s sake, Quast, can you move on?” stay with me. If we don’t understand how ETFs are affecting equities and what risks they present, it’s our own darned fault. So, let’s learn together.
As I was saying, ETFs don’t pool assets. Instead, firms like Jane Street gather up baskets of stocks and trade them straight across at a set price to ETF sponsors, which in turn “authorize” APs, thus the term, to create an equal value of ETF shares wholesale in large blocks and sell them retail in small trades.
I explained to Brian Sullivan how the math of the stock market shows a collapse in stock-liquidity. That is, the amount of stock one can buy before the price changes is down to about 135 shares (per trade) in the S&P 500. Nearly half of trades are less than 100 shares.
Block trades have vanished. The Nasdaq’s data show blocks are about 0.06% of all trades – less than a tenth of a percent. Blocks are defined as trades of $200,000 in value and up. And with lots of high-priced stocks, a block isn’t what it was. For BRK.A, it’s 1.5 shares. In AMZN, around 130 shares.
Yet somehow, trade-sizes in the ETF wholesale market have become gigantic. Risk.net says 52% of trades are $26 million or more. A quarter of all ETF trades are over $100 million. Four percent are over $1 billion!
And almost $3 TRILLION of ETF shares have been created and redeemed so far in 2019.
Guess what the #1 ETF liquidity criterion is? According to the Risk.net study, 31% of respondents said liquidity in the underlying stocks. Another 25% said the bid-offer ETF spread.
Well, if stock liquidity is in free-fall, how can ETF liquidity dependent on underlying stocks be so awesome that investors are doing billion-dollar trades with ETF APs?
We’re led to believe APs are going around buying up a billion dollars of stock in the market and turning around and trading it (tax-free, commission-free) to ETF sponsors.
For that to be true, it’s got to profitable to buy all the products retail and sell them wholesale. So to speak. My dad joked that the reason cattle-ranching was a lousy business is because you buy your services retail and sell the products wholesale.
Yet the biggest, booming business in the equity markets globally is ETFs.
We recently studied a stock repurchase program for a small-cap Tech-sector company. It trades about 300,000 shares a day. When the buyback was consuming about 30,000 shares daily, behaviors heaved violently and Fast Traders front-ran the trades, creating inflation and deflation.
That’s less than a million dollars of stock per day. And it was too much. Cutting the buyback down to about 10,000 shares ended the front-running.
I don’t believe billions in stocks can be gobbled up daily by ETF APs without disrupting prices. Indeed, starting in September we observed a spiking breakdown in the cohesion of ETF prices and underlying stock-prices and a surge in spreads (not at the tick level but over five-day periods).
But let’s say it’s possible. Or that big passive investors are trading stocks for ETF shares, back and forth, to profit on divergence. In either case it means a great deal of the market’s volume is about capturing the spreads between ETFs and underlying stocks – exactly the complaint we’ve made to the SEC.
Because that’s not investment.
And it’s driving stock-pickers out of business (WSJ subscription required) with its insurmountable competitive lead over long-term risk-taking on growth enterprises, which once was the heart of the market.
The alternative is worse, which is that ETF APs are borrowing stock or substituting cash and equivalents. We could examine the 13Fs for APs, if we knew who they were. A look at Jane Street’s shows its biggest positions are puts and calls. Are they hedging? Or substituting derivatives for stocks?
Public companies and Active investors deserve answers to these questions. Market regulation prohibits discriminating against us – and this feels a lot like discrimination.
Meanwhile, your best defense is a good offense: Market Structure Analytics. We have them. Ask us to see yours. We see everything, including massive ETF create/redeem patterns.