In the past few weeks, we have teased a few thoughts on the issues we see in ETF’s. This week, we’re going to start a series called “The Problems in Your ETF.” Today’s post centers again on the levered ETF’s.
Many (negative) market commentators point to Central Bank purchases of stocks as a looming issue – i.e., Central Banks have no business buying stocks, their purchases have helped push stocks to artificially high levels, and when those purchases inevitably reverse, stocks will get crushed, etc, etc. Given their status as a buyer of last resort, their tendency so far to be long term holders, we’re not sure why Central Banks are bad shareholders. But that’s beside the point, which is: why does no one talk about the skew introduced into the markets by the levered ETF’s?
Once again, our friends at FlowPoint Capital have supplied us with the necessary research. FlowPoint looked at 788 ETFs in the US that have greater than $1.0 million in average daily trading volume. The total average daily value traded in this group is $65.6 billion, or 28% of all US equity trading. The total market cap of these ETFs is $2.9 trillion, or only 9.4% of the entire US equity market capitalization. You starting to see the disconnect?
The average ETF in this universe trades four percent of its market cap per day, and the average holding period is 162 days. The $235 billion SPY, for example, trades eight percent of its market cap every day, which amounts to a 15-day average holding period. In contrast, its buy-and-hold Vanguard cousin, the $80.0 billion VTI, has a 340-day average holding period.
The problem really is with the geared or levered ETF’s. While some non-levered ETF’s have holding periods of 700 days, $93.0 billion in ETF market cap averages a holding period less than ten days, and most of that is in levered ETF’s which are designed specifically to encourage daily trading. Does this concentration in levered ETF’s presage a potentially looming problem for equity markets? Here it is graphically:
Look at the geared Direxion gold miners, the DUST (3x short) and NUGT (3x long). The DUST has $273 million in market cap but trades $189 million per day. The NUGT has $1.5 billion in market cap but trades $300 million per day. Its swaps are based on the Vaneck gold miners’ ETF (GDX). But, not too long ago, stories in the press appeared noting the issues GDX was having meeting subscriptions and redemptions. And that was just because the GDX was growing rapidly. What happens when volatility spikes and everyone runs for the door? What about the swaps the NUGT has on the GDX? You know why no one knows? Because neither the NUGT or the DUST existed in 2008. They were created in 2010 and have only known stable markets.
The TQQQ, your favorite 3x levered technology play, owns $1.8 billion in tech stocks, including $100.0 million in AAPL. It was also only formed in 2010. When all the fish start swimming in the other direction, what will that leverage unwind do to stocks? Our point is that the number of shares owned today by short term shareholders is ominous. Levered Bull funds outweigh levered Bear funds in number and in assets. So, while it’s nice to have the Bear funds to supply liquidity in Bear markets, they will get swamped by their cousins. And it isn’t just the levered vehicles. Some of the widely owned country and sector ETF’s have shockingly high turnover rates, which will only get worse in a prolonged selloff.
Remember when the Flash Crash in ETF’s was an issue? That was two days in August 2015. What happens when it turns into something real, when people are actually paying attention? It’s easy to pick on the levered ETF’s. The real concern ought to be with the un-levered, widely held ETF’s. Many names in the ETF universe, mostly created after 2010 and untested in bear markets, attract tourists and not investors. That’s a problem. Portfolio insurance, a brand-new product and untested in Bear markets, exacerbated the 1987 crash. Long-Term Capital, everyone’s favorite pariah, was a brand-new concept when it almost caused markets to melt down in the late 90’s. Risk parity funds are brand new. And so are many ETF’s.