Liquidity: ETF Flash Crashes

Series: Liquidity

This series explores how market liquidity has been drying up in recent years, sowing the seeds for a much more violent rout when the next financial crisis arrives, how the investment community is quietly preparing for the eventuality and what you should do about it.

Concerned by the dearth of liquidity, the investment community is quietly engaged in disaster preparation. How should an individual investor prepare also for the eventuality?

Sensing the ripening opportunity for shorting in the illiquid high yield bond and ETF markets, the lead wolves amongst the hedge funds are preparing for the kill.

The flash crashes of some of the largest blue chip tracking ETFs on Aug 25 should serve as a warning of what’s to come for their smaller and illiquid high yield brethren.

Faced with mounting losses in their bond portfolios and massive redemption requests, mutual and hedge funds begin suspension of any and all redemption requests. The next phase of the junk bond crisis has begun.

On August 25 the S&P 500 declined by 4%, marking the largest single-day decline for US stocks since the turbulent days of the financial meltdown in 2008.

As unsettling as it is with a decline of this magnitude on a single day, what went on beneath the surface, and went almost completely unreported by mainstream media, should serve as a warning shot across the bow for those complacent about the stability of the stock market in general and ETFs in particular.

As it turns out, the opening 30 minutes of the stock market witnessed a complete breakdown. Instead of a single market-wide flash crash such as experienced in 2010, the market was bombarded with a countless number of mini-flash crashes with an unprecedented wave of halts and un-halts as the market came in and out of cardiac arrests.

The cause? The high frequency trading (HFT) algorithms simply went haywire with the amount of price dislocations. Claiming to be the provider of market liquidity, many of these parasitic computer algos, which legally front-run your orders during normal times, went MIA and preferred to step aside until the turbulence subsided.

Even more alarming was that during these initial chaotic minutes, which saw the market drop about 10% right off the gate, the ETFs fared much worse. MUCH worse. In that span of 30 minutes, circuit breakers were tripped on these ETFs over 600 times, accordingly to Zerohedge, and the price declines of these ETFs, whose net asset value are supposed to be in lockstep with their underlying stocks, were far greater than the indexes they are supposed to track.

The $65 billion iShare Core S&P ETF (ticker IVY), the 2nd largest EFT in the world which tracks US blue chips, dropped 26% right off the open, some 20% more than that of the index before recovering to the index later in the day. Other big name ETFs which experienced the same crashes included the $19 billion Vanguard Dividend Appreciation (VIG) and the $12 billion SPDR S&P Dividend (SDY) which both plummeted about 38%, according to Casey Research.

ETF crashesBig ETFs suffered catastrophic declines during the flash crashes of Aug 25 2015 (image: Casey Research)

 

Imagine yourself having placed a stop loss order against your ETF positions as a prudent measure. On that day, your stop loss order would have turned into a market order and got executed at a devastating loss to your nested eggs.

As argued in our earlier series (Liquidity: the Next Deadly Buzzword), the market structure has been gradually eroding in recent years partly as a result of HFT infestation and evaporating liquidity. If large ETFs like IVY can flash crash, image what it would be like for those high yield ETFs with practically zero liquidity.

Protect your portfolio accordingly.

 

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