Suppose gas prices changed 3% daily.
Pretty soon everyone would look for patterns in volatility and start rushing to fill tanks at low ebbs. Or maybe there’d be a Gasoline Closing Cross, where petrol consumers would cue and then all carom into the pumps to peg the best average for the day.
Daft, you say? How come we do it in equity markets? On a recent day a big energy company was trading 85,000 times on intraday volatility of 3.2%, meaning the spread from highest to lowest price ranged 320 basis points. It traded less than 200 shares at a time but $16,000 a pop and $1.4 billion total. And 40% was middle men moving price.
So a trader wanting $1 million of stock would chance the market 63 times to get less than a percent of daily volume, with 40% of trades front-run by packs of transient intermediaries, and price would’ve changed 3% throughout the day-long effort.
What if you spent your day driving around trying to fill your gas tank and 40% of the time when you pulled into a station somebody darted into your spot? And the pump price shifted at each glance.
At some point you’d quit driving. In a sense, active investors are driving less, choosing instead ETFs, the assets for which have doubled in three years in part because they function opposite the broad market where prices are a buzzing guywire of instability.
When money flows to ETFs, brokers designated as Authorized Participants manufacture large batches of ETF stuff called creation units. As the Investment Company Institute explains (page 3), they alone interact directly with the ETF’s distributor (and the ICI says 15 sponsors have 90% of ETF assets). They’re following the “recipe” described in an ETF’s prospectus but making enough for a mess hall and supplying straight to big investors or to a chunk of sub-distributors ranging from other brokers to hedge funds and high-frequency traders.
In effect ETFs cut out the middle men (or let them in the back). They’re everything the broad market isn’t. There’s a preferential relationship (the AP) with exclusive access to the source of the money, which is the distributor of the ETFs (Blackrock, Vanguard, Invesco, Janus, BNY Mellon etc.), and the two parties know exactly who each other is.
Don’t ETFs trade like stocks? The ICI data, you might counter, show 90% of ETFs have no daily creation or redemption. That proves they’re trading vehicles, appearing or vanishing through APs at inflections unlike other shares.
If this model is booming, why is the broader market built the opposite way, clogged with intermediaries and tiny shreds of fast-moving shares obscuring perverse liquidity paucity coalescing in forced anonymity around frantic price-instability? ETFs are created in 25,000-unit chunks but somebody buying the energy company gets 200-share snippets. Which would you take?
Why don’t public companies ask the SEC the same question? If the market for the audience we court year-round appalls upon examination, should we help active investors? (That requires understanding why ETFs are mushrooming, which IR should explain to management.)
We should wish to know why investors who believe in long-term fundamentals get one crappy market while ETFs get an advantageous another. In a bizarre upending of function, the market intended for capital-formation has been constructed to favor derivatives. ETFs don’t listen to earnings calls.
This caprice explains volatility of recent weeks. The market is bifurcated into one that works well if you use derivatives like ETFs and one that doesn’t if you don’t.
Now, you say, “But Quast. Some big ETFs nearly collapsed on Aug 24.”
While the S&P 500 have been reducing share-count by percentage points annually through big buybacks, indexes and ETFs have exploded and the use of derivatives like options and futures have set soaring new records.
Translation: Underlying assets shrink as extrapolations of those assets expand. The same thing happened in mortgages. Demand was huge so mortgages were sliced and tranched and repurposed into collateralized obligations that swelled well past underlying assets but carried the same value. What popped that bubble wasn’t the first missed mortgage payment but an end to asset-appreciation.
Derivatives become unreliable when the underlying assets stop appreciating. Ponder that. And look back.
Options expire next week at the same time the Fed meets and may hike rates or not, and S&P indices rebalance following a period of high market gyration. Everything may sort into neat piles. But comportment rarely follows caprice. Drama is more common.
So prepare your executives, and make it a mission to get them involved in the structure of this marketplace. It’s in your power.
