If you need further proof that the world is still macro-driven—a fundamental precept Matt Hougan was spouting off about yesterday on CNBC —then let’s engage in a little exercise.
Unless you’ve been in a cave—which is entirely possible, bear with me—then you probably saw that trading volumes just hit the year low . If you missed that little news bite, it’s probably because you have indeed been in a cave, along with a large cadre of investors.
There’s nothing tremendously surprising about this—it’s August, it’s been hot and the “wait and see what the Fed does” disease has latched on pretty hard to a big chunk of the market.
But a priori, how would you expect low volumes to impact ETF investors? To answer that, you have to make some assumptions about what kind of investors have been spending time in the proverbial cave.
Conventional wisdom—for as long as I’ve been in the markets, which dates back to the crash of ’87—is that volume variability is driven primarily by speculation.
The theory goes that there’s a base level of transaction activity driven by long-term strategies that will occur regardless of market conditions.
Your payroll deduction hits; you mechanically buy some mutual fund shares; that mutual fund mechanically buys some stocks. Or, if you’re a retiree, you have a long-term divestment plan going on, mechanically selling a bit each month. Endowments have cash to reinvest, sovereign wealth funds have scheduled rebalance activity, and so on.
So when volumes dip, the money that’s not in the market on those sleeper days are folks chasing earnings reports, betting on volatility spikes, swinging for the fences in small-caps. That doesn’t necessarily pigeonhole the sleepers as hedge funds and prop-desks.
After all, Matt Hougan has been known to take an ill-conceived flier in his less-than-hedge-fund-sized Schwab account from time to time. So let’s just call the missing dollars “hot money” and not fret too much about whether it’s from Berkeley, Calif. wage slaves or Darien, Conn. Ferrari leasers.
With that mental picture in mind, what do you think happens to ETF investors? Let’s cut to the tape:
The gray background is consolidated tape volume. Note that this doesn’t suggest yesterday was the lowest day of the year.
Commonly quoted stats are the volume on NYSE. But a tremendous amount of volume trades off NYSE, so in our analysis, we generally always look at the complete, consolidated tape, which includes not only NYSE and Nasdaq volume, but OTC and bulletin board trading, and all of the fragmented exchanges like BATS so beloved by high-frequency traders.
The top red line is the percent of that total volume—in dollars—represented by ETF trades. The bottom blue line is the percent on share count. Since the median ETF handle is much higher than the median stock price handle, share volume isn’t very representative, so we tend to focus on the red line.
So what does this chart tell us?
It tells us that when speculators drive volumes up—such as they did in the heady days of June this year, ETFs are overwhelmingly their tool of choice. On this year’s peak volume days of more than 13 billion shares, ETFs peaked at 34 percent of value traded. Just a few weeks later, in the summer doldrums we’re in now, ETF share-of-trading has plummeted to just 17 percent of value traded.
Put another way, when the markets get boring, ETFs get really, really boring. And here’s where the red flags should start going up.
How has this affected specific ETFs? Here are a few test-case ETFs I use for analyzing liquidity—some of these will look familiar. First off, let’s start with the ETF industry’s poster child, the SPDR S'P 500 ETF (SPY).
As you’d expect, volumes are down, and below even the recent averages, but at 107 million shares trading every day, it’s still one of the most—if not the most—liquid security in the world. SPY will continue to trade a penny wide and at fair value until long after I’m dead and buried.
What about just a bit further down the liquidity curve? I often look at the WisdomTree Emerging Markets Equity Income Fund (DEM), because it’s in a fairly illiquid corner of the market, but one that investors seem to maintain interest in:
Here you can start to see some chinks in the armor of on-screen liquidity.
Where DEM was trading nearly 2 million shares a day in June, it’s fallen to about 800,000 shares a day. For almost any investor, this is great liquidity, and it’s been bid a penny or two wide throughout these volume spikes and dips.
So where do you start getting in trouble? Let’s take a look at the SPDR Nuveen High Yield Muni ETF (HYMB).
Here’s where the crazy stuff was really happening in June, as munis got clobbered and HYMB lost significant value.
The fund was trading hundreds of thousands of shares a day, and all sorts of useful price discovery for illiquid munis was taking place thanks to ETF traders.
Now, however, we face the ketchup bottle problem. You may have tried to grab the falling knife back in June, and are sitting on shares you need to push through 5-cent spreads and very low daily volume.
Here’s where smart trading would really matter. If you’re sitting on 30,000 shares of HYMB bought at the low of 51.23 in June, there’s no guarantee you can realize the gains you’ve made. In fact, based on the posted book, you may not even really have any gains, despite the “last price” on this chart:
To move 30,000 shares through this thin book, you’re going to start hitting bids at 51.14. Of course, smart trading—either by working this trade very carefully or through a liquidity provider—could probably do a lot better than that, but dumb trading would wipe out any gains you’re feeling good about.
And lastly, let’s look at an ETF that was already having some liquidity issues—the United States Brent Oil ETF (BNO):
I love this ETF. I really do. The Brent/WTI spread has been one of the most consistently interesting stories in commodities for the past few years, and BNO came to market just in time for investors to really make calls on contango and backwardation on the global stage.
And that’s why BNO will consistently have trading volume of 100,000 share days. But, at times like this—when all the speculators are in their caves—BNO becomes extraordinarily tricky to trade. Not impossible; just fraught with peril and opportunities to get hosed by smarter traders than you.
The moral of the story here is simple:Don’t assume that “quiet” markets make for easy ETF trading.
ETFs are easiest to trade, consistently, when the market is frothy and full of speculators. That speculation keeps spreads tight, keeps ETFs trading closer to fair values and makes midlevel blocks much easier to trade.
Times like these—the dead zones—are actually the most dangerous.
At the time this article was written, the author owned a tiny, ill-considered and underwater position in HYMB. Contact Dave Nadig at firstname.lastname@example.org.
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