Matt King: Global QE And “ETFs Everywhere” Have Created An Unstable, One-Way Market
While the financial industry remains divided over what precisely is the cause of the malaise that affects modern markets, characterized by plunging volumes and trading activity, record low volatility and dispersion, a relentless ascent disconnected from fundamentals, and generally a sense of foreboding doom, manifested by an all time high OMT skew – or record high price for crash insurance – as discussed previously…
… it can agree on one thing: it has something to do with the interplay of QE, the artificial force that has disconnected market prices from values for the past 8 years, and ETFs, which as some prominent investors have said are “devouring capitalism.” They also agree that the combination of QE and ETFs have made the market almost entirely “one-sided”, and thus prone to collapse when conditions finally reverse.
Indeed, as Citi’s Matt King – our favorite sellside cross-asset strategist – writes in his latest report, a growing number of institutional managers, from Oaktree to Elliott to Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided.“
King points out a trend observed among the financial literature over the past 2-3 years (starting with Howard Marks’ March 2015 note in which he asked, rhetorically “What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains”), “everyone’s number-one suspect in potentially creating such a tendency seems to be ETFs. In Paul Singer’s memorable words, passive investment through the likes of ETFs “is unsustainable and brittle” and “is in danger of devouring capitalism”.
But are ETFs really to blame, King wonders, or simply a symptom of some other underlying tendency? His answer is the latter, and begins with an explanation we have shown many times on this website: the relentless shift away from active to passive management:
It’s easy to see why active managers are complaining. Over the past ten years, the cumulative inflow to US HY mutual funds is precisely zero, while HY ETFs have netted $40bn. In US IG, where inflows have been stronger, more than a quarter of the money over the past decade has gone to ETFs; in EM FI in recent years, the proportion is more like one-third. For European credit, ETF outstandings may look far smaller, and yet these belie the true size of the threat since (unlike the US) most trading occurs OTC and hence goes unrecorded. All of these are nothing compared to the massive rotational shift being seen in equities, in which around $500bn has flowed away from active managers and into ETFs over the past 12 months alone, and where ETFs now account for over one-quarter of markets’ traded volume.
It’s not just investors who are worried about ETF flows: regulators are too, having become “alarmed at the dramatic growth in ETFs, focusing in particular on the potential for a sudden reversal, notwithstanding ETF managers’ robust defence that ETFs’ potential to trade at a discount to NAV gives them an additional escape valve relative to traditional open-ended mutual funds.”
But, as King shows in the following chart, there is a puzzle here, or rather a pair of them. “Rather than being the fickle retail fad of the popular imagination, ETF flows have actually proved much more stable than mutual fund flows (Figure 1). Either the potential for a future reversal is far greater than anything seen in the historical data, or the problem is not unique to ETFs.”
Furthermore, it is odd for fund managers – professional investors trained to capture market short and long-term market inefficiencies – to be complaining about something which in principle should be creating additional opportunities for them.Here King makes an absolutely spot on point about inefficient markets, which however we have to note, is only relevant inasmuch as central banks don’t do everything in their power to perpetuate the inefficiencies, now in their 9th year:
Indiscriminate buying and selling by ETFs should add to the potential for active managers to spot mispriced securities. The greater the proportion of trading done by passive entities, the greater should be the opportunities.
So are fund managers simply suffering from a case of sour grapes, King asks, “or is there some other factor preventing these opportunities from occurring in the way theory says they should be?”
His answer for why the current market regime has made active investors a species facing extinction, is due to two things: record low volatility and record low dispersion:
The obvious culprit is the lack of volatility. Our Cross-Asset Volatility Indices show that realized volatility now stands at multi-decade lows in every major asset class bar FX (Figure 2). But even worse for active managers is the lack of dispersion. A manager can still make money when markets themselves are involatile provided there is sufficient variation in the performance of individual securities. Dispersion, or the cross-sectional standard deviation, effectively captures how much a manager with perfect foresight could have made by overweighting the best performing securities or sectors and
underweighting the worst performers. Dispersion in both credit and equities is now at the lowest levels on record.
As Citi points out, this lack of potential for outperformance might seem surprising on the back of obvious single-name sell-offs like Teva or Provident Financial. However as he explains, “these names have been too small to offer much outperformance potential: even managers who had zero-weighted them prior to the sell-offs would only have increased total returns by 1.4bp with Teva in € and 1.3bp with Provident in £ respectively. To outperform, managers need there to be multiple names moving in opposite directions – to have, if you like, a genuine two-way market. The only market which has come close to this description in recent years is the only one where volatility is not making new record lows: FX. Is this a coincidence, or a feature?”
King then reverts back to this key point: the confluence of QE and ETFs have led to one-way markets, in which the main feature is investor clustering, and herding: “for us, the real damage in markets in recent years is an increase in herding. ETFs are contributing to this tendency but they are not its primary driver.“
The result is an increasingly illiquid market: “What we think has been happening in recent years is that investors are displaying an increased tendency to position themselves the same way round. In the process we are therefore losing the heterogeneity which is the source of a liquid market. This tendency is likely to have been strongest in the markets where the price action has largely been one-way. With the notable exception of markets with currency pegs, FX has some built-in protection against this because its securities automatically have two sides. Thanks to the fragmented nature of trading and the large role carry plays in driving returns, credit is particularly vulnerable.”
Of course, it’s not just the shift to passive investing that is forcing active investors to group together for their very survivla: other factors are also exacerbating this trend.
“The combination of global credit growth and QE has created such a sustained bull market in many asset classes that investors are inevitably concluding that their best trade is simply to close their eyes and go long the market in the cheapest way possible. ETFs in principle offer a panoply of potentially uncorrelated factors, but in practice trading volumes have been overwhelmingly concentrated on the major indices. The rise of algorithmic trading and regulators’ increased tendency to insist on marking to market likewise build in a short-termism which is likely to be self-reinforcing. Whatever factor or trade has been doing well is likely to receive inflows; whatever has been doing poorly will be shifted away from.”
Which brings us to the conclusion: whether QE is the driving force behind ETF-mediate herding, or some different factor is responsible, the trouble with one-way markets is that they are not really one-way, and as Citi’s King warns “wooner or later the herd turns around. This creates a risk that current record lows in volatility are misleading.”
Here King points out something we brought to readers’ attention last week when we showed the record high cost of market crash insurance: “To some extent this is reflected in high levels of OTM skew, but conceivably not enough given the potential for asymmetry.”
The problem, according to Citi – and certainly central bankers who however will never admit this in public – is that when the herd has been moving in one direction for long enough, it becomes hard to envisage what might turn it around. For credit investors, the “buy on dips” mentality has become deeply entrenched – even if the justification for doing so is never valuations, and always “the strength of technicals”.
Typically these are attributed to some sort of irresistible but poorly understood external force, such as mutual fund inflows (in IG, but interestingly not HY at present) or “the strength of the Asian bid”. Rather like the blurb from a London estate agent which recently landed in my letter box, investors are urged to buy precisely because prices have gone up so much: the idea that the demand which led to those price rises might one day reverse is unthinkable.
Still, despite the “fake markets” of the past 8 years, in which every dip has so far been bought – profitably – Citi says that investors should be thinking about such reversals, preferably before they actually occur.
Will mutual fund inflows always remain strong even as deposit rates rise? Will Japanese investors’ bid for US credit remain as intense even as reduced BoJ purchases mean private investors have to absorb more net supply in JGBs, or are there signs that is fading already. In particular, what is the potential for abrupt discontinuities on this front?
The answer, according to King, very high, but “to say that this or that threshold is automatically a danger” is not the point: Citi’s punchline is that increases in herding, or equivalently a reduction in the diversity of the investor ecosystem, create large asymmetries which are in themselves a threat to financial stability – whether or not they are accompanied by financial leverage, something which not even Fed presidents can grasp.
And yet, while King can warn until he is blue in the face, the reality for an entire generation of “investors” in artifical markets is that no matter what happened, risk assets would keep going up, as did mutual funds and ETFs. That may change soon: King looks at fund flows among equity and debt (IG and HY) fund flows, and calculates that the standard deviations and maximum moves, are much larger for outflows than for inflows – modestly so in some cases, shockingly so for equities.
Even if ETF flows have not shown this tendency to date, there is every reason to think that both ETF and mutual fund flows will exhibit these characteristics in future. One-way markets trend for extended periods with very little volatility, but are then vulnerable to abrupt turnarounds.
All of the above leads King to an ironic conclusion, one which we have discussed previously and which we will comment on more shortly, namely that in this fake market, the one thing that can potentially save the active management community, is a reversal, or as King puts it, “paradoxically, the very thing required to save active managers is a reversal of the conditions which gave rise to their tremendous growth in the first place.”
Namely, a crash. Unfortunately, with central banks more concerned than ever that markets can simply no longer function on their own without daily central bank support, a crash, or even a correction, may not happen… or rather when it does, trading would simply shut down as this “one-way market” can no longer even discount such a simple alternative outcome as “selling.”