I wrote an piece a week and a half ago about the “Implication and Price Discovery of ETF Hedge on Illiquid Securities & The US Treasury’s Public-Private Investment Program(PPIP)” which focuses on the intraday risks and potential dislocation of the nature of ETFs, which was well received by a few experienced investment professionals and not by a few. This actually reminds me of a quote from a scholar I follow on Twitter about “It’s better to argue and question a group rather than an individual…” which also indirectly reminds me of one of the many CIA and FBI strategic points I studied on Quora about how it’s relatively easy to remove an asymmetrical risk/individual in their context of reinforcing homeland security but it’s very challenging to eliminate an ideology. Anyways, back to the discussion of ETFs. I will focus this article on two concepts; intraday risks and dislocation, potential trading arbitrage opportunity for non ETF-based securities and ETF pulling (instead of pushing) the demand, therefore the price, of the underlying securities.
Arbitrage on non ETF-based Securities
Given the inherent inefficient nature of ETFs (though it’s relatively more “efficient” or some narrowly defined as higher liquidity than most financial instruments out there, aside from the securities themselves), it presents an arbitrage opportunity for market makers because (1) they take all the upside net fee and (2) it is clearly stated that they are not obliged by law to enter into the market of market making if they choose to not do to so, most often times, in illiquid, high-spread scenarios aka no downside risk.
Besides the inefficient mechanism of ETFs, you should also worry about if investors and your friends know the top 10 holdings in their “Green, Cybersecurity, “Drive the Future” and China A-share ETFs. I don’t know about you but I sure do know a big handful of people who doesn’t know what their ETF is composed of. This is an interesting point because Redfin published in their monthly report ~mid-2017 that >60%+ of young buyers didn’t even see the real estate in person and were very willing to commit to a real long-term financial commitment.
Could this be a sustainable market driving force as information opaqueness has decreased exponentially in just a decade or less and access to information is more fluid and transparent or is this a short-term fad (like the frozen yogurt boom in late 2000’s and perhaps the hype over juicing for my generation right now)?
But these two points actually bring another interesting perspective into the thought process in that since almost an overwhelming amount of the securities out there are now bundled in some sort of ETFs, the question then becomes which securities aren’t bundled in an ETF because this might present an opportunity not from investing in an up market (which is what we are still going through in Oct 2017) but more in a down market. Bear in mind we are not saying we can predict or catch the bottom, just utilizing the opportunity in the market structure.
If the underlying security is not included in any ETFs, the risk is therefore contained to the price of the security itself, hence one can just study the financial fundamentals to determine what is a cheap and expensive relative to other securities. However, if an underlying security is bundled in ETFs (i.e. Apple and other “popular” high exuberance stocks are bundled is an overwhelming # of ETFs), then trading these you not only have to study and manage the financial fundamentals (balance sheet/cash flow/financial statement perhaps in this order) but you also have study the complex interconnectedness of ETFs in a price-adjusted market. This is the easier approach.
The more challenge and perhaps potentially more lucrative opportunity is to leverage on the point that human nature have the tendency to avoid mistakes and glorify any small feats, therefore in this situation, massive selling of the ETFs might push the underlying securities’ price below the financial fundamentals, which by itself is an arbitrage. But there are more way more unknowns to manage relative to the first approach.
This will be one of the many points of observations, studies and opportunities towards the beginning of the next cyclical nature of the credit cycle.
Feel free to comment below or PM your perspective.
I will be posting neutral viewpoints on topics ranging from macro/equity/housing market to the function of society, to human psychology and more! I am trying to get into the habit of writing the thought process down right now so I can backtest it in the future. Follow me on LinkedIn and Twitter.
Intersection notepad 