Matt King: Global QE And “ETFs Everywhere” Have Created An Unstable, One-Way Market

While the financial industry remains divided over what precisely is the cause of the malaise that affects modern markets, characterized by plunging volumes and trading activity, record low volatility and dispersion, a relentless ascent disconnected from fundamentals, and generally a sense of foreboding doom, manifested by an all time high OMT skew – or record high price for crash insurance – as discussed previously…

… it can agree on one thing: it has something to do with the interplay of QE, the artificial force that has disconnected market prices from values for the past 8 years, and ETFs, which as some prominent investors have said are “devouring capitalism.” They also agree that the combination of QE and ETFs have made the market almost entirely “one-sided”, and thus prone to collapse when conditions finally reverse.

Indeed, as Citi’s Matt King – our favorite sell-side cross-asset strategist – writes in his latest report, 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.”

King points out a trend observed among the financial literature over the past 2-3 years (starting with Howard Marks’ March 2015 note in which he asked, rhetorically “What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains”), “everyone’s number-one suspect in potentially creating such a tendency seems to be ETFs. In Paul Singer’s memorable words, passive investment through the likes of ETFs “is unsustainable and brittle” and “is in danger of devouring capitalism”.

But are ETFs really to blame, King wonders, or simply a symptom of some other underlying tendency? His answer is the latter, and begins with an explanation we have shown many times on this website: the relentless shift away from active to passive management:

It’s easy to see why active managers are complaining. Over the past ten years, the cumulative inflow to US HY mutual funds is precisely zero, while HY ETFs have netted $40bn. In US IG, where inflows have been stronger, more than a quarter of the money over the past decade has gone to ETFs; in EM FI in recent years, the proportion is more like one-third. For European credit, ETF outstandings may look far smaller, and yet these belie the true size of the threat since (unlike the US) most trading occurs OTC and hence goes unrecorded. All of these are nothing compared to the massive rotational shift being seen in equities, in which around $500bn has flowed away from active managers and into ETFs over the past 12 months alone, and where ETFs now account for over one-quarter of markets’ traded volume.

It’s not just investors who are worried about ETF flows: regulators are too, having become “alarmed at the dramatic growth in ETFs, focusing in particular on the potential for a sudden reversal, notwithstanding ETF managers’ robust defence that ETFs’ potential to trade at a discount to NAV gives them an additional escape valve relative to traditional open-ended mutual funds.”