While the press is waxing lyrical about the unprecedented loss caused by a sell off in FANGs (Facebook, Amazon, Netflix & Google) we should note that it overlooks one factor. Before getting to that, to start with the sell off in gross dollar terms it is unsurprising given the already highly inflated value of the base stocks. So if A $500bn market cap Facebook loses 4% it is equivalent to $20bn. On one day FB lost a Fiat Chrysler. It’s math. Let’s not forget that Bitcoin is now worth $165bn but let’s not let that bubble spoil the party.
The problem that faces financial markets is the advent of ETFs. While stupefyingly simple to understand as an investor it is that same simplicity that breeds complacency. ETFs are simple products that enable investors to pay much lower fund management fees to buy easy to understand baskets- whether coal, gold, oil or FANGs. There are 106 ETF products that own Facebook as a Top 15 holding with that averaging between 5% and 10% of the entire fund.
Yet on the way up things are rosy. It is what happens on the downside that has yet to be fully tested. Around two years ago, CM wrote a report which warned of the risk of ETFs on the downside, especially levered ETFs (i.e. you buy a 2x levered FANG fund which means if FANG stocks go up 5% you theoretically get 2x the return for any given move up or down.
However in times of uncertainty (i.e. heightened risk) the options markets that price risk move magnitudes on the downside vs the upside. Meaning for an ETF to replicate what it proclaims on the brochure becomes much more difficult meaning the fund may under or overshoot the promises. Also in certain markets (e.g. US & Japan) where stocks on the exchange have limit up/down rules on the physical stock, should a market crash ensue, the ETF prices on the theoretical values of stocks that may not have opened for trading. What that means is that the ETF may reflect a market that is 10-15% below where it actually eventually opens. Meaning poor ETF buyers get gouged. However the computer algorithms in the ETF end up chasing, not leading the market which in and of itself creates more panic selling further reducing market confidence. Where a market might have traditionally fallen 3% on a given piece of bad news, ETFs tend to react in ways that might cause a market to retreat 6%. Indeed market volatility is amplified by ETFs.
At the moment market behavior is exceedingly complacent about risk. Before GFC highly complex products like CDOs and CDSs were the rage. 99% had next to no clue how they operated but they found their way into the local government investment portfolios of even small country towns in Australia.
ETFs on the other hand are strikingly simple to grasp but that also means we pay far less attention to the risk that goes with them. That is the bigger worry. People complacently thinking their portfolios are safe as houses may wake up one morning wondering why some flash crash has caused Joe and Joanne Public’s retirement nest egg to get decimated.