Warren Buffett was quoted as saying that derivatives were weapons of mass destruction. I would argue that Warren has it wrong! When the next market correction comes and it will, probably sooner then everybody who has been investing in this market at these levels will soon find out. It will not be derivatives that will exasperate the market down move, but it will be ETF’s (exchange-traded funds). Over the past three years the inflows into these “passive investments” has been massive. Retail investors are moving their money from good old mutual funds that are actively managed by a portfolio manager or a group of portfolio managers who try to beat a benchmark like the S&P 500. Investors have been upset with the fact that these managers have been unable to beat their benchmark, so with lower returns and higher fee’s investors are moving new money and old, to index funds and ETFs that are set up to match an index or sector, not beat it.
Also, there has been a ton of tv ads brainwashing investors that this is the new way to invest and the media a has been talking no stop about how active management has underperformed over the past five years, and active management is pretty much dead. Which if history teaches us anything that means we should be investing in active management not leaving. But that is a whole other topic to be discussed later. Let’s also throw on top the fascination from many investors, with the tripled levered ETFs.
Now, I do not think we will have another 2008 scenario. However, I truly believe that the next correction will be a hell of a lot worse then people think and it will be different from past corrections. Why? Its pretty simple, ETF’s have changed the access investors have to the marketplace, especially retail investors. ETF’s by design gives investors the ability to buy and sell anytime they want at a low cost. In years past retail investors invested in mutual funds where you could sell anytime you wanted, but your NAV is calculated at the end of the day which makes trading very cumbersome for investors to buy and sell one mutual fund over and over, plus the fees that they would incur. An ETF is like a stock; you can buy and sell it has many times as you want in a single day and for a pretty low commission. I know huge hedge funds that use ETFs on a daily basis to get exposure to certain sectors and then are out at the end of the day or the next day buying and selling millions of shares of these ETFs daily.
Now try to imagine the current environment we are in right now, the market is making new highs every day. Investors who are in the market are happy as can be but worried about when is the right time to get out, to lock in their profits. Investors who are not in the market and have been waiting for a pullback are worried that they might miss out on the next move up, and now they are starting to buy these ETFs to get exposure. And then on top of that, you have hedge funds looking for exposure to the long side in certain sectors to make up for lack of performance. It is a perfect storm for a nasty down move. I am not talking about 10%, try 30%. This down move will be intense, and it’s because of a combination of the access, algorithms and then good old fear and greed. The access will allow a ton of investors to start to sell their ETFs to lock in profits, and then the fear will kick in. After seeing that their portfolio was up 25% and is now only up 15% and then they look one morning and see that the market did not rally back as it has done over the past six years. Then more investors and more investors will start to sell. Then algorithms that are supposed to supply liquidity in the market by making hundreds of thousand small trades shut off because they do not want to take any more risk. What happens then is market liquidity drys up and the spread between the bid and ask(price of where you can buy and sell) gets super wide which adds to the down move. It basically becomes a shit show.
You say it can’t happen, look at the four days in August 2015, the last real true sell-off we have experienced. The sell-off started on Thursday, August 20th and ended on Tuesday, August 25th, but the morning of Monday, August 24th , 2015, was what scared me the most. The velocity of the down move was something I have never seen in my 22 years of trading. After pondering what I had seen that day, it dawned on me that the combination of the access, the levered ETF’s and algorithms proved to me this new phenomenon, that ETF’s were the next weapons of mass destruction.