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Thinking through volatility in ETFs and financial markets

Dan Rohinton's picture

Global markets were jolted Monday morning with elevated volatility as a group of ETFs fell intraday between 25% to over 40% within minutes of the market opening, which triggered a broader correction. In short order, well known blue chip firms such as GE, Pepsi, Visa and Starbucks briefly fell over 15% before recovering. It’s worth highlighting that the seeds of this volatility were sown years ago with the growth of ETFs in the market and the risks they pose to their investors.

On Monday as volatility picked up, the ETF traders significantly raised their fees (wide bid-ask spreads), some even halted trading altogether. This meant either no bids for investors looking to sell ETFs (no liquidity) or a very low bid (significant capital loss) if there was a buyer. Owners of popular ETFs were put in a very difficult position of being unable to sell or take a loss on their investment of between 25-40% in less than 30 minutes. This is a problem unique to the ETF structure and represents one of the risks investors are taking on when owning ETFs, even the "liquid" ones.

Source: Jonestrading (as of Aug. 24, 2015)

Ever since the financial crisis, the industry has seen a significant shift away from mutual funds into ETFs. Since 2011, U.S. mutual funds have seen redemptions of just over $143 billion while U.S. ETFs have attracted inflows of $251 billion. These passive strategies, with a preset formula for trading, have played an increasing role in the financial markets by buying and selling en-masse a basket of securities without any regard for the significant differences in quality or valuation of the underlying businesses. It’s also no coincidence that ETF activity represented 30% of trading volume in the market on Monday, the largest day on record since data has been collected.

Source: RBC Capital Markets

As a consequence of the new regulatory requirements, the traditional investment banks have a limited capacity to act as a buffer during periods of market volatility in both equity and fixed-income markets. Overall the total balance sheet for dealers has shrunk around 80% post-crisis leaving traditional market makers in position where they are either unwilling or unable to step in to correct irrational prices. This magnifies the volatility and increases the level of illiquidity in the market during periods of uncertainty.

During these times we aim to take advantage of irrational selling in the market often driven by passive strategies forced to liquidate based on a rigid formula. We remain focused on absolute returns and building positions in quality companies at attractive prices (driven by market dislocations) as important steps in the process.

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