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The Muscular Portfolios Newsletter — No. 20 — Sept. 25, 2019
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East Coast seminars: Sept. 28 & 29
Seats are still available for two seminars led by Brian Livingston this month.
• The first seminar, at the Philadelphia MoneyShow, is one hour in length. Admission to the MoneyShow is free, but preregistration is required.
• The second seminar is an in-depth teach-in. It is four hours in length (plus coffee breaks and a no-host lunch) and also requires preregistration.
Get your ticket today. The fee for the in-depth seminar goes up after Sept. 27.
For details on both events, see our seminar page.
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Will ETFs crash the market? No.
 By Brian Livingston
A well-known trader has aroused the financial media by claiming that exchange-traded funds are in a bubble and will lead to a market crash. Among the contrary responses, the head of an investor-education organization states that ETFs are nothing like the toxic mortgages that contributed to the global financial crisis of 2007–2009.
My name has been invoked in the debate, so I think it's important to clear up what causes a crash and what doesn’t.
Who is Michael Burry?
The controversy began when Bloomberg News reported on Sept. 4 an email interview it conducted with Michael Burry of Scion Asset Management in Cupertino, California. Burry is known for predicting in 2005 that mortgages sold to moderate-income home buyers would default when the “teaser rates” expired and the buyers couldn’t make the higher payments.
He bet heavily against the packaged mortgages — known as collateralized debt obligations (CDOs) — that were at that time being profitably sold by lenders. Burry reportedly made $100 million personally, alongside his hedge-fund clients who gained an astronomical 489% in less than eight years. Burry’s prediction was written up in Michael Lewis’s 2010 book The Big Short, and he was portrayed by the actor Christian Bale in the 2015 film of the same name.
In his recent interview with Bloomberg (Figure 1), Burry said: “Passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies — these do not require the security-level analysis that is required for true price discovery.”
He added: “This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”
The “Nobel-approved models” he spoke of include VaR (Value at Risk). This formula previously assured banks that financial products with a certain degree of volatility had only a small chance of large losses. VaR, along with many other decades-old theories by Nobel laureates, was proven wrong by the financial crisis. Bear Stearns, Lehman Brothers, and other “too big to fail” institutions learned this the hard way by collapsing during the global financial crisis.
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Figure 1. Bloomberg News devoted several minutes on Sept. 4 to a debate on Michael Burry’s assertion that index funds are in a bubble. Video by Bloomberg News.
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Burry went on to tell Bloomberg that the smallest half of the stocks in the Russell 2000 small-cap index have less than $5 million in trading volumes per day. His implication was that those small stocks will have big losses in a market crash as investors in small-cap equities all head for the exit at the same time.
This latter assumption, as well as Burry’s whole thesis about index funds in general, was challenged on Sept. 16 in a video by Ramin Nakisa, a former investment banker.
Who is Ramin Nakisa?
Nakisa is now a co-founder of PensionCraft, an investor-education project based in the United Kingdom. PensionCraft is a consulting group that is not a wealth-management firm. Instead, it offers individual investors low-cost investment seminars and live question-and-answer sessions.
In his new video, Nakisa points out that exchange-traded funds that track small companies are not required to buy and sell every company in a category. ETFs can and do use sampling. In other words, ETFs can buy a correlated selection of such stocks. As an illustration, Nakisa shows that the iShares FTSE 250 ETF, which indexes 250 small-cap stocks in the UK, actually holds only 237 stocks. That is a sample. The ETF has excluded some small stocks that may be hard to buy and sell.
More importantly, Nakisa says, “This is a well-known fact.” As evidence, he cites a MarketWatch column I published on Jan. 9, 2019. It showed that bid-ask spreads — the small haircut you take whenever you buy or sell a stock or an ETF — can be 100 times larger for the smallest micro-cap stocks than for a stock in the highly liquid S&P 500 or a popular ETF. For instance, the spread can be 7% to buy and sell a microcap stock, but only 0.07% to get in and out of an ETF or a giant S&P 500 stock.
Regarding the illiquidity of a few ultra-small stocks, Nakisa adds: “ETFs have found a way around that” — namely, the use of sampling. Figure 2 shows my graph of the bid and ask spreads of different-sized securities, which Nakisa reproduced in his video.
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Figure 2. The very smallest microcap stocks — smaller than low end of the Russell 2000 small-cap index — can cost you a much larger spread than popular ETFs and stocks in the S&P 500. Source: ETFScreen.com study via Brian Livingston/MarketWatch.
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Nakisa’s most telling criticism of Burry is that “a CDO is not an exchange-traded security.” CDOs cannot be bought and sold on an exchange, only through private channels. Most importantly, the CDOs that contributed to the global financial crisis — and put many financial firms out of business — were highly leveraged.
For one thing, CDOs are leveraged by the mere fact of millions of renters buying houses with borrowed money. In addition, many of the CDO packages were rated triple-A. (AAA is the highest rating, given to bonds that are judged to have almost no risk of default.) Traders happily borrowed huge sums of money to buy in, thinking CDOs were as safe as Treasury bills, just with much higher yields.
Unfortunately, the triple-A ratings were bestowed by Standard & Poor’s, Moody’s, and Fitch Ratings, which were paid by CDO issuers to write favorable opinions. The Congressionally-mandated Financial Crisis Inquiry Commission concluded in 2011 that these credit-rating agencies were “key enablers of the financial meltdown.”
This conflict of interest in rating bureaus has never been fully overcome. But fortunately, ETFs are not like CDOs. ETFs do not use leverage and do not rely on subprime mortgages that were doomed to default.
The market will crash, but ETFs won’t be the reason
For my part, I have no doubt that the US stock market will crash within the next few months or years. The valuation of equities is simply too high. Further, America’s 10-year bull market is so old that buyers will sooner or later stop paying such steep prices for stocks. Fortunately, when equities start falling, the asset-rotation formula of Muscular Portfolios will tend to keep informed investors in whatever asset classes are going up in any given month.
The US equity market has crashed 30% or more every 10 years, on the average, over the past 80 years. Four long-term formulas that project the expected 5-year return of the S&P 500 — used by the celebrated investor Warren Buffett, famed economist Robert Shiller, and others — predict somewhere between a mere +2.6% gain and a distressing minus-4.6% loss, annualized over the next 5 years. These projections are illustrated in my Mar. 9, 2019, MarketWatch column.
In my view, Burry’s sensational prediction glosses over a crucial difference between index mutual funds and index exchange-traded funds.
When you sell, say, $100,000 worth of mutual fund shares, the fund manager must give you $100,000 in cash. If the fund’s cash reserve is low, the manager must actually sell $100,000 worth of stocks from the fund’s holdings to raise cash to pay you. Those sales can drive down market prices.
ETFs are different. When you sell $100,000 worth of ETF shares, the ETF sponsor is not obligated to sell any of the underlying securities. Instead, some random third party is paying you $100,000, because he or she wants your ETF shares for a 401(k) account or whatever. The ETF sponsor is not a party to the transaction. Only rarely is it necessary for a sponsor to sell any stocks at all.
That will keep ETFs from triggering any panic selling. To be sure, there will be a rout in equity markets some day. But it will be caused by bad news or a shock to investors’ expectations, not by any flaw in ETF design. All it would take to start a sell-off these days would be an oil shock, a trade war, or any of a dozen other possible scenarios. We’re seeing the early stages of oil and trade shocks at this very moment — and things can get worse, fast, at any time.
During a crash, you may not get the price you’d like, but you’ll always get close to a fair-market price from an ETF. (This excludes “flash crashes,” which are computer glitches that drive prices crazy for a few minutes before they stabilize.)
Further, our two Muscular Portfolios never hold any investments in the crash-prone S&P 500 or the tiny-stock Russell 2000. Instead, large-cap stocks are represented in Muscular Portfolios by the Russell 1000 — a very broad index that routinely outperforms the S&P 500. Small-cap stocks are represented by the S&P 600, which comprises only profitable small-cap stocks. The S&P 600 far outperforms the Russell 2000, which includes numerous money-losing small companies. (See the June 1, 2018, newsletter.)
The good news — as I reported in the Aug. 16, 2019, newsletter — is that both of the Muscular Portfolios shifted entirely out of equities and into safe (and profitable) investments in bonds, gold, and real estate by July 31. The Mama Bear and Papa Bear will always tilt toward whatever asset classes are going up and away from those that are going down. All you have to do is enjoy the ride.
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The Burry discussion begins at approximately 3 minutes 35 seconds in the Bloomberg News video, which is linked to from a Bloomberg article.
The segment on my warning about the high bid-ask spreads of microcap stocks begins at approximately 12 minutes 10 seconds in the PensionCraft video.
Both programs are worth watching in their entirety. Happy investing!
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