The Real Financial Crisis Will Be Caused By ETFs

Includes: TFCVX
by: Wall Street Daily

By Tim Maverick

2016 continues to be "The Year of Living Dangerously" for stock market investors. And we're only a little more than three weeks into the New Year!

So far, China has featured in most of the headlines when it comes to market risk, followed by oil prices. But there's another risk - lurking right here in the United States - that threatens to add even more risk to an already volatile mix.

We already caught a preview of this in 2015 - the very real potential risk caused by ETFs.

History Lesson

Before I delve into the current risks, I want to remind investors about a time when untested financial innovations added to a financial crisis.

Many - including economist John Kenneth Galbraith - say one key factor in the crash of 1929 was the new innovative financial instrument called the investment trust, formulated by Goldman Sachs (NYSE:GS). Yes, the "vampire squid" was around then too.

Investment trusts were the precursor to today's mutual funds and ETFs, holding a basket of stocks. But they used a unique form of leverage.

For example, say Company A invested in companies B and C; Company B invested in companies C and D; Company C invested in companies D and E, etc. And along the way, bonds and preferred stocks of these firms were also sold in the marketplace.

It looked like a perpetual cash machine to the public. Until it all crashed. But thankfully, Goldman escaped unpunished (ha!).

Lack of Liquidity

Modern-day innovative instruments include both leveraged and inverse ETFs. These funds use leverage in a different way - through derivatives - which Warren Buffett has called "financial weapons of mass destruction."

The Securities and Exchange Commission (SEC) is clearly worried, because by the middle of last year, these ETFs had a record $63 billion in assets. And that number is climbing rapidly.

On December 11, the SEC considered a proposal to limit the amount of derivatives - and therefore leverage - these ETFs can use. Fresh in the SEC's mind, no doubt, is how credit derivatives nearly brought down the financial system in 2008.

SEC Commissioner Luis Aguilar said, "Why ETFs proved so fragile that [August] morning raises many questions and suggests it may be time to re-examine the entire ETF ecosystem."

But even without the derivatives factor, the SEC is right to be worried, based on what we saw in 2015. Even regular ETFs caused headaches.

And in this case, the size is larger in magnitude. The overall ETF industry now has $3 trillion in assets. Overall, ETFs globally attracted $372 billion in net inflows in 2015. And in 2015, roughly $70 trillion worth of ETFs changed hands.

During the August swoon/flash crash, supposedly safe ETFs (more than 1,000) had circuit breakers implemented on them more than 600 times! And even though the stocks inside the ETFs were down 10% or so, some ETFs plummeted by as much as 35%. And those were the lucky ones - many ETFs didn't price at all for many hours.

The Wall Street Journal looked into what happened after circuit breakers were initiated on many stocks. And here is the lowdown:

Many ETF market makers were unable to accurately calculate the value of the underlying holdings or properly hedge their trades. That caused them to lowball their buy offers and overprice their sell orders to ensure they didn't take on too much risk. This sent ETF market values tumbling and caused disruptions in the trading of other assets.

The disruption in trading of other assets is really concerning. And whatever happened to all that much-advertised liquidity? It seemed to disappear quicker than a wisp of fog.

Future Shock?

The point I want to make to readers is the following:

An ETF can never be more liquid than the underlying securities in the fund.

Liquidity is extremely important. Just ask the shareholders in the Third Avenue Focused Credit Fund (MUTF:TFCVX), where redemptions were halted in December thanks to the lack of liquidity in the underlying junk bonds.

I have this nightmare scenario from extrapolating what happened in August…

At some future date, after the proliferation of ETFs and stock buybacks has continued unabated for years, then a true, prolonged bear market may emerge.

Will the stock index ETFs have a scenario similar to what's currently true in the gold and silver markets?

That's where there are more people that have a claim on the underlying assets than the assets that are truly in the ETF. Not good if everyone rushes the exit at the same time.

It'll probably never happen. But caveat emptor with regard to ETFs.