EC ‘The Biggest ETF In Town’

One of the key dynamics to grasp when it comes to explaining why global equities and credit have rallied to nosebleed levels is the interplay between central bank liquidity and passive flows.

This is a world where central banks have created a global hunt for yield and then supercharged it by working on both the supply and the demand side of the equation. Buying up corporate bonds with freshly-printed money weighs on supply and the very act of funneling trillions into the market creates demand by driving yields into the floor.

Of course that has the effect of ultimately pushing investors into equities – especially when it reaches a point where yields on corporate bonds are lower than dividends on stocks.

Thanks to the rampant proliferation of ETFs, investors can now ride this wave via any number of passive vehicles that ostensibly offer liquidity in all corners of the market. That funneling of cash helps to make the wave even bigger and, as we outlined in “The Wave Paradox“, makes it virtually impossible for market participants to distinguish between riding the wave and creating they wave they’re riding. Recall this:

The concept is simple: market participants of all stripes are no longer able to discern whether they are capitalizing off the prevailing dynamic or creating the dynamic that they’re capitalizing on.

This can be posed as a question: “Am I making good decisions or are the decisions I’m making only turning out good by virtue of my having made them?”

That might sound like the worst kind of tautological bullsh*t, but it’s not.

If the former is true (that is, you made a good decision by getting long an asset that subsequently appreciated in value), then the fate of that asset going forward is largely independent of what you do next.

If the latter is true (that is, your decision to get long an asset was a non-trivial part of why that asset subsequently appreciated in value), then the fate of that asset going forward is in part contingent upon what you do next.

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“A growing number of institutional managers, from Oaktree to Elliott to Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided,” Citi’s Matt King wrote, in a note out last month, before adding that “around $500 billion has flowed away from active managers and into ETFs over the past 12 months alone in equities where ETFs now account for over one-quarter of markets’ traded volume.”