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The Illusion of Liquidity Could Be Dangerous in the Next Crisis

High-frequency trading and algorithmic trading strategies became immensely popular in the years following the Great Recession. Likewise, exchange-traded fund products have gained traction with a market seeking diversification and an approximation of the "market return" with as little cost as possible.

While ETFs, high-frequency trading funds and algorithmic strategies have undoubtedly prospered during the long and stable bull market that took off in 2010, it is far from clear how they will perform in harsher market conditions. Indeed, there is increasing reason to believe their value, especially their furnishing of seemingly instant liquidity, may be more illusory than most investors currently believe.

The rise of high-frequency trading and ETFs

As the Wall Street Journal reported in late December, exposure to high-frequency trading strategies has exploded to unprecedented levels in recent years:

"Today, quantitative hedge funds, or those that rely on computer models rather than research and intuition, account for 28.7% of trading in the stock market, according to data from Tabb Group -- a share that's more than doubled since 2013. They now trade more than retail investors, and everyone else. Add to that passive funds, index investors, high-frequency traders, market makers, and others who aren't buying because they have a fundamental view of a company's prospects, and you get to around 85% of trading volume."

Likewise, ETFs have moved from being a niche component of the market, as they were pre-recession, to one of the most dominant and impactful forces in publicly traded markets. As a consequence, there is a huge amount of passive money trading, often being driven by the actions of high-frequency trading and algorithmic market movers.

Lurking danger

We have discussed the potential dangers of algorithmic and high-frequency trading previously. The issue is summed up quite effectively by Marko Kolanovic, chief of macro quantitative and derivatives research at JPMorgan Chase & Co. (JPM), who gave a rather candid opinion to Bloomberg in a Dec. 1 interview:

"We're seeing reaction times get shorter and shorter for releases, which can also incur costs or take advantage of slower human investors. There are signs of potential abuses with social media posts and headlines. That's going to get worse and worse and be more of an impediment for human investors to make money. It's going to cause more confusion in the marketplace...At some point that's going to end up badly--most likely when the next recession hits."

We got a taste of this danger in late December last year, when the market experienced one of its most violent selloffs since the end of the Great Recession. Neal Berger of Eagle's View Asset Management attributed the magnitude of the market swoon to high-frequency and algorithmic trading programs, abetted by the huge amount of totally passive money flowing in response to these movers:

"The speed and magnitude of the move probably are being exacerbated by the machines and model-driven trading. Human beings tend not to react this fast and violently."

The illusion of liquidity

December's market crisis may have passed, but the issues it raised with the fundamental structure of today's market architecture cannot be dismissed. Charles Himmelberg, co-head of global markets research at Goldman Sachs (NYSE:GS), has discussed the inherent fragility in the supposedly robust and liquid markets underpinned by high-frequency, ETF and algorithmic strategies:

"One theory that has been proposed for why market fragility could be higher today is that because HFTs supply liquidity without taking into account fundamental information, they are forced to withdraw liquidity during periods of market stress to avoid being adversely selected. In our view, this at least raises the risk that as machines have replaced people, and speed has replaced capital, the inability of the market's liquidity providers to process complex information may lead to surprisingly large drops in liquidity when the next crisis hits."

Venture capitalist Josh Wolfe has gone even farther, recently opining that the widespread belief in computerized liquidity, and the easy diversification provided by passive ETFs, may be unfounded:

"You have the illusion of liquidity, because you have daily trading & ETFs...I think that there's a real risk of permanent impairment, which is the true measure of risk of principal."


The market today is not like anything witnessed in history. It is extremely reliant on computerized liquidity, while at the same time unprecedented amounts of capital are essentially passive, in the form of ETFs. Taken together, we can see an exceptionally dangerous scenario in which selloffs beget selloffs and capital flows grow increasingly chaotic.

Investors with significant exposure to these trading and investing vehicles, which have never been tested in the crucible of a bear market, let alone a recession, should consider moving their capital to more stable, or at least more understandable, asset classes.

Disclosure: No positions.

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This article first appeared on GuruFocus.