Home > Uncategorized > 2011/07/06: ETFs Matter: More Risk Than Apparent… and Trend Tails Affect Markets

2011/07/06: ETFs Matter: More Risk Than Apparent… and Trend Tails Affect Markets

To both the public and professional trading communities Exchange Traded Funds, better known as ETF’s, must look like a winning proposition. There are many reasons that the rapidly expanding number of the specialized trading vehicles that are on offer can indeed be of  benefit. However, there are also risks, especially for retail investors who might not be as adept as those in the professional trading community at understanding the full nature of these instruments they are buying or selling. Yet, we can not disagree with the proposition that the ability to make specialized investments in subsectors of broader asset classes, or manage risk on positions that occur well after the beginning of a particular trend appears to be very attractive.

And that has never been more so the case than in present markets that have such significant divergence of trend potentials. That is driven by major negative ‘outside’ possibilities (tail risks) within what we are consistently told is a generally improving situation, even for the lagging highly developed Western economies. In addition to any of their other advantages, it makes ETF’s a very good vehicle (especially for retail investors) to attempt to profit from extended market trends while still tightly managing risk.

For the average investor, and even professional capital markets participants, it all feels a bit like Dorothy’s trip through Oz: “Chinese rate hike, Portuguese downgrades and US debt ceiling, oh my!” Of course, some of these things are readily discounted as overblown compared to the reality that is likely to ensue. The third Chinese rate hike this year is simply a further step in cooling a previously overheated economy; and everyone is hoping/suspecting they can achieve a ‘soft landing’.

The downgrade of Portugal’s government debt is still not as bad as the situation in Greece; and even in the latter it is now assumed that even in the event of a default being declared by the credit rating agencies the ECB will continue to accept its paper (with a further lowering of the ECB’s collateral standards.) And as significant a problem as the US debt and fiscal situation might be, it looks like the Democrats have run out the clock on the Republicans, forcing everyone to accept an interim deal that will avoid striking the grand bargain that will include major entitlement program reform. That will now wait for another day.

A final note on the current investment/trading background as it relates to the influence of ETF’s on the underlying markets: There is probably something to be said for both the overall improvement in general economic conditions across the cycle, and the potentially dire nature of the “tail risks.” However, both in  light of those primary divergent influences, and also even allowing for the classical anticipatory nature of markets, a somewhat significant amount of recent market activity appears to be more distorted than usual.

The recent activity in the September S&P 500 future (as a proxy for the other equity indices as well) seems to be driven by some sustained buying or selling that goes beyond classical tendencies. Along with that significant divergence of overall trend potentials, our hunch is that this is due to the ease with which retail investors can now feel comfortable managing risk in extended trends.

First, A Bit on ETF’s

There was an interesting article in the Financial Times a couple of months ago by their always well-informed credit markets supremo Gillian Tett (“Why ETFs give an uneasy sense of déjà vu“, May 5, 2011.)  Allowing that they are less pernicious than CDO’s (collateralized debt obligations), which were the highly opaque bit of financial engineering that led to the financial crisis, she noted the risks that were recently highlighted by none less than the UK Financial Stability Board, including…

“…therein also lies a possible risk: precisely because ETFs have a reputation for being so ‘dull’, it is uncertain whether investors do understand all the potential risks. Not least because ETFs (unlike CDOs) are often sold to retail investors.”

“And even if investors are wise enough to understand the risks of individual ETFs, the bigger structural impact is not well understood. The FSB, for example, fears that liquidity mismatches and poor collateral practices could create unpleasant markets jolts in a crisis. It also notes there are potential conflicts of interest because of ‘the dual role of some banks as ETF provider and derivative counterparty.

“And there is another, more basic concern: precisely because the market has exploded with such stunning speed, it may be changing flows in unpredictable ways.” That last bit is the sort of distortion we think we are seeing in some of the resilience of trends even as the news obviously shifts against the recent price swing…” (More on that below.)

All in all, quite a thorough review of the benefits that also highlights the new risks
that ETF pose. However, as I noted in my letter (which the FT Editor was kind enough to publish) expanding upon her review of this area (“Retail investors should treat funds with some caution“, May 20, 2011), even the estimable Ms. Tett “…falls into a trap of consistently characterising retail investors as “investing” in these instruments. In addition to the more creative structures which have evolved of late, there is also the matter of ETFs not being an investment in the classical sense. Much as with stock futures, while quite a few of them are based on various baskets of stocks, they are not an equity investment per se. They do not pay dividends, split, etc.”

“Purchasing an ETF thereby falls significantly more to the side of the market activity divide that can be characterised as trading rather than investing. As such, it is much more of a speculation in almost all cases. …in addition to clarity on technical details of any ETF’s structure, retail investors would be well-advised to bear in mind the general nature of that activity.”

Last but not least on this matter, another of our favorite writers at the Financial Times further explored the entire topic back on May 27. In “Drawback with ETFs lies in their advantages” John Authers  points out in the first instance that ETF’s “…allow retail investors access to whole asset classes that were previously in effect closed to them, and they allow for easy expression of a macro view.” Of course, the latter had previously been the province of major financial institutions and their brethren at the well-capitalized hedge funds.

Yet, even in consideration of that, he sensed that the sheer size of the market left the door open to various forms of misunderstanding or misuse. In spite of the benefits to any individual investor, he suggested three good reasons “…it  might make sense to restrict ETF’s growth.” First, they enable and encourage herding. Second, they speed up markets and encourage short-termism.

The last issue can get back to something akin to “truth in advertising”. There is a potential for less than well-informed investors to be disappointed by the performance of the specific Exchange Traded Fund to match that of the underlying market or index. As Mr. Authers put it, “ETFs can foster confusion. Difficult financial engineering goes in to ensuring that an ETF’s price moves in line with the asset it is supposed to be tracking.” And, “The collateral that ETF managers hold at any point can vary widely from what it says on the label.”

General Market Implications

Interesting that so many recent sharp price swings have continued to ‘grind’ in the same direction even as the initial volatility cooled down. While the vast expansion of algorithmic trading has created additional directional price volatility when a trend gets moving, that is more so about continued progress in the direction of the current aggressive trend. However, the additional phenomena we are referring to is the ability of markets to maintain stuck near the near-term endpoint of a trend (typically into the next significant technical resistance or support) without any of the classical counterpoint reaction.

While that is the case in many markets of late (including gold, energy markets and foreign exchange as well as fixed income), the clearest recent examples have occurred in the wake of some of the equity market rallies. When the June S&P 500 future recovered from the sharp mid-March selloff, the rally stalled into April 1 in the important 1327-34 area. It spent the next five sessions churning sideways against that resistance, yet without slipping back below the 1,320 area. Classical historic tendencies would have been more likely to exhibit a somewhat more significant setback from that area after no more than two or three days of being stalled.

And the next example of that same sort of tendency seems to be occurring at present. The explosive rally of the September S&P 500 future from near the 1,250 major support last week back up to that same resistance is now at a standstill around the top of the 1,327-34 area. Again, this does not appear to be related to the now ubiquitous algorithmic trading, as that is typically only triggered once momentum is signaled; which is most certainly not the case since the high end of the rally was hit last Friday.

As John Authers also noted in his article (in the section on the initial problem of ‘herding’) “…ETFs neatly channel investment in a given sector into the specific securities included within their  funds.” We have a feeling (not confirmed by any empirical evidence at this point) that retail investors who are hesitant to buy markets when they’re under pressure are employing Johnny-come-lately tactics to chase sharp moves.

They have been empowered through ETF’s ability to manage risks more closely than the equivalent exposure in the underlying positions; and it is reasonable they can indeed manage the risks better, even in those cases where the position does not work out well. As such, while they may cut and run once a trend starts to reverse, retail investors chasing any given market can cause the near-term aggressive price swing to be sustained around its endpoint for longer than was classically the case.


As noted previous, the most important technical development last week was last Tuesday’s September S&P 500 future recovery back above the previous week’s 1,293.30 high. That had both technical significance (a fresh UP Break out of its overall DOWN channel above the 1,290-88 area) as well as psychological implications. The latter was by virtue of exceeding the previous week’s high that was set during the disappointing Fed economic forecast downgrades and downbeat press conference by Chairman Bernanke.

That leaves the next decision (which will be important for other asset classes as well) whether the September S&P 500 future can also continue its resilient bid back above the prominent 1,327-34 resistance; and ultimately also violate the 1,351 Tolerance of the potential topping activity on both the contract and continuation charts.

Market tendencies are likely to follow those noted at other early phases of the corporate earnings announcement season, with the notable exception that weak economic data and crisis threats might put a better bid back in the government bond market. That much is already apparent from the long-dated govvies futures being back into or slightly above their next resistances even as equities keep the bid. Those key levels include September T-note future 122-24/-14, September Gilt future 121.00-30, and September Bund future back above 126.00-125.70 to actively test 126.50-.65. In spite of this near-term recovery from the sharp selloff last week occurring in conjunction with an equities bid, the next aggressive equities swing coming out of the current near-term range is likely to be a source of somewhat significant counterpoint for the govvies and short money forwards.

Foreign exchange also seems to be skewed a bit by the crisis potential, as the US dollar is atypically firming up even as the equities keep the bid. Especially now that the US Dollar Index held on the pressure back into critical support around the major .7417 November 2009 low (due to the near-term up trendline in that area), it was only natural that it could bounce as equities stall. As noted in our other research previous, that works hand in glove with the inability of the euro to push above its EUR/USD 1.4500-1.4600 resistance any more convincingly than on the previous trip early last month. That will remain key resistance for quite a few reasons, while 1.4100-1.4000 (with a Tolerance to 1.3900) remains critical support.

August Gold will likely be influenced by the flow of information on the peripheral European Debt-Dilemma. Its crisis ‘haven’ role is now significantly highlighted by the degree to which it was down sharply (to the low end of 1,490-80 support) when equities were up on better economic sentiment due to the improvement of the Greek situation late last week. Yet it has ratcheted back up sharply to the top of the 1,520-30 resistance in the wake of the renewed concerns about the European debt situation. Much above 1,530 the 1,550 and 1,560 areas remain resistance.

After August Crude Oil had been range bound in the wake of sharp early-May selloff, continued economic weakness finally led to violation of 95.50-94.50 support; at which the market failed on the attempted recovery rally prior to the very burdensome release of stocks from the Strategic Petroleum Reserve two weeks ago. However, recovery back above 95.50-94.50 is a sign of what a limited market influence any move of that type is in fact. Resistances remain in the 101-102 and 105-106 ranges.

Thanks for your interest.

“FT” and “Financial Times” are trademarks of the Financial Times.

© Copyright The Financial Times Ltd 2011.

Categories: Uncategorized Tags:
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: