Two quotes that sum up the inherent danger of ETFs in a market drop

Two quotes that sum up the inherent danger of ETFs in a market drop

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.
— James Rickards
Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares.
— Frank Holmes

For the last few years the mantra given to individual investors is to avoid stock picking and just invest in an index-following ETF. And while this has worked well on the ride up the bull market it has some inherent risks when the market reverses. Simply put, the ETF Index Funds need to approximate the move of the index by buying and selling the underlying stocks. So when the index goes down because some of the stocks that comprise it are dropping the ETF manager must sell those same stocks.

This creates a dangerous cycle because the ETF selling will exacerbate the drop in price of the underlying stock - which will cause it drop in price some more - which will cause more selling from the ETF. You get the point.

This sort of a mechanical move by the ETF will cause the value of the ETF to decline as well. When ETF holders see that they will try and sell their shares, which will cause the price of the ETF to decline some more. And so it goes…

The point is that the ETF industry has sold the concept of Index-following ETFs as a “safe” investment strategy. The reality is not so clear.

Play Safe out there and always know your Risk,

Black Mountain Halloween Pet Parade

My least favorite McCain thing: Not learning the correct lessons of Vietnam

My least favorite McCain thing: Not learning the correct lessons of Vietnam