I still can’t shake the feeling I got from how Monday’s Flash Crash 2.0 went down. Investment funds like ETFs are supposed to be stable instruments to build long term wealth, and the SEC let fast money accounts take 30% or more from average retail investors. Before Monday, I never thought that ETFs could separate so drastically from the price of their underlying holdings, but now we know. Now that we have ultra fast computers and everything is run on algorithms, what might the next crisis look like and how can we be prepared?
I was on a team that managed mutual funds with assets in the billions of dollars. While they weren’t fast moving ETFs that got traded in real time, they were still tough to manage, especially if we needed to sell something. We had big redemptions only one time while I was there. We lost $400 million in a day, a figure that only represented 0.4% of our assets. The head of fixed income came over and exclaimed a word I won’t repeat, and that was for 0.4% of our assets. We had a hard time finding buyers to get enough money in cash so we could meet investor demands for their money back while keeping our reserves stable.
I was a trader for bond funds, which are really illiquid. That means you can’t get a lot of money out at once without causing massive collapses in prices. My company ran reserves of about 4% in case they had massive redemptions because there’s no way we could get a bunch of money together in a hurry if investors demanded it. This is a mutual fund we are talking about too, and these products are generally pretty stable. Individual investors used to own a lot more actual stocks and bonds. Granted they paid ridiculous fees to own them in their brokerage accounts, and these individual securities were pushed on them by brokers that didn’t know how to read a financial statement any better than a manual in Chinese, but they owned them. If there was a massive selloff in the markets, these investors had to call their broker and give explicit individual instructions on each stock or bond if they panicked. So if individuals used to own all the stocks where are they all owned now?
This chart is stunning. Look at the light blue part of the graph at the top: that’s the individual investors. Right after WWII they owned about 90% of the stocks in America. Now mutual funds own about 20%. They are the largest owners besides individuals. This chart is as of 2013. Since Vanguard has had a couple record breaking years of cash flow, I would imagine this number has grown even more in favor of mutual funds. So we have more money tied up in fewer investment funds than ever before. While in a chaotic market environment you used to have to be able to get ahold of your broker and give him all the specific instructions of what to do, now all you need to hit the panic button is an internet connection.
You can logon to your mutual fund website and press sell in a market correction and throw gasoline on the fire. I saw this happen several times in the muni bond market where investors would really start freaking out after a few days of losses and start selling even more. It’s not logical behavior but it drives markets.
Are Mutual Funds “Too Big to Fail”
Ever since there was a run on money market funds (checking accounts for rich people) during the financial crisis and the key short term funding operation for corporate America froze, the government has been paranoid about a run on mutual funds. To be honest they probably should be. The Fed talked about making Blackrock and Fidelity “Significant Financial Institutions” because of the danger to the financial system these companies would pose if investors ever tried to pull their money out at once. Instead of many different small orders to sell, you would have massive orders to sell that no one firm could actually meet so the result could be a freefall in the market.
I thought it was funny that Vanguard got left out of the list of firms that might get this hated designation in the industry. It’s probably because most government officials have their accounts there. The reason behind trying to slap on tons of regulation on these big players is that market conditions could deteriorate and people couldn’t get their money out of mutual funds. The resulting panic could trigger another Black Monday like when the markets fell over 20% in 1987.
What New Vulnerability Did Monday’s Flash Crash 2.0 Show Us?
I think it exposed a whole other level of vulnerability in the system that Americans use to save and invest for retirement. I’ll say again just so people know I’m not anti-ETF that I think ETFs are fine to use for professional advisers or individual investors that know how to use limit orders. However, I think ETFs pose a unique market risk that mutual funds do not. ETFs were not nearly as big in 2008 as they are today. In fact the $500 billion industry of 2008 pales in comparison to the $3 trillion behemoth now. Since we have a much larger set of ETFs to choose from, it is harder for market makers to make sure the value of the stocks that are in them is roughly the same as the price of the ETF. We just saw how these common investment products are at greater risk than stocks of falling apart during market collapses just when normal folks are prone to panic selling. That’s what’s got me worried the most.
The new rules that stop trading in super volatile securities have made ETFs way more vulnerable than stocks. There are about 3000 stocks in the US but the number of ETFs will soon surpass them. We just saw that when markets are selling off and we have high volatility, those market makers are going to step back completely and let vulture high speed trading firms come in and buy up assets from average investors at extreme discounts because they know how to play the game and the mom and pop folks don’t. So what we could see in the next crisis is a double whammy where the massive indexed mutual funds and ETFs send the largest companies stocks into a tailspin because their sell orders will not be able to be met by any one firm. Individual investors using mutual funds would likely fair much better in this environment as they will be getting whatever the asset values of the mutual funds are at redemption, though if enough people pulled their money out investors might not be able to get all their money at once in an extreme event.
The ETFs though could get terrible execution in the next crisis as the financial firms that are supposed to provide balance in their prices would pull back like they did Monday. So you have a choice, do you accept the risk that a systemically important mutual fund with hundreds of billions of assets might not be able to meet all the sell orders or the risk that your ETF price might be 30-40% away from the true value of the holdings because market makers refuse to provide bid ask spreads like they are supposed to? I’m going to suggest a third way that’s not very popular in the personal finance advice world.
Buy Individual Stocks and Bonds and Make Your Own Index Fund
In light of how the next crisis might play out where you would choose between being able to get your money or getting bad execution, I thought I’d bring another alternative to your attention that could be the ETF and Mutual Fund Killer: it’s called Motif Investing (this is not an affiliate link, I actually like this company’s idea). This startup allows you to invest in 30 stocks at once for a flat fee of $9.95. They don’t allow limit orders or other things that you really need to trade in micro cap or over the counter stocks, but this offer works fantastically well for larger corporations.
Consider if you had $100,000 invested. You need to pay a 0.10% expense ratio if you are at a cheap firm like Vanguard, or $100 a year. Instead, if you looked in the ETF holdings reports that are always publicly available by government mandate, you could randomly select 30 stocks and get a high likelihood that you will match the index’s underlying return based on the Central Limit Theorem.
So say you want to build a group of stocks with a growing dividend. Instead of buying VIG, Vanguard’s Dividend Growth ETF that lost 37% of its value on Monday in a severe collapse, why not go to Vanguard’s website, look up the holdings of the ETF, and randomly put your finger on 30 of them, then go to Motif Investing and buy them? You would save $90 the first year and $100 every year after using that example from earlier. Furthermore, you never risk having the ETF closed on you and being forced to take a bunch of capital gains, and you don’t risk the market suddenly breaking down if you ever needed to sell. If you ever did need to raise cash, you can choose what stocks you want to get rid of rather than dumping the cheap and expensive stocks equally.
You can more efficiently do Tax Loss Harvesting if you want to spend the time doing that, and unfortunately you will have a harder time selling all these individual holdings, though that might actually protect you during market downturns. After what we saw with the ETFs collapsing, I refuse to give my complete trust out anymore. If there were ever mass selloffs in ETFs and mutual funds large companies will probably get destroyed with deep drops because those are the stocks that will need to be sold to get the money to meet redemptions. In those times ahead I’m hoping for a more stable existence from my motley portfolio of individual stocks, which is effectively the Travis Do Nothing Portfolio.
Instead of finding out how ETFs and Mutual Funds and their indexed stock lists perform when EVERYONE has their money in the same five or six funds, I’m adding individual stocks to my holdings emphasizing modest dividends. I’ve bought a lot of oil stocks and emerging markets, and while the ride has been extremely bumpy, I think it will pay off in the end.
Make sure you take advantage of new technologies that exist now like Motif Investing, and soon to be widespread Robin Hood brokerage that will allow you to trade for free. You can build your own index fund based on your own rules and you will likely do as good or better than the market if you just never sell. In this brave new world of market volatility, exploding corporate pay packages, and flash crashes, I think it would be a good thing if more average investors owned the actual honest to goodness meat and potato company shares again, and we now have the tools to do it. In the meantime, just don’t press any sell buttons on ETFs without listing prices first because it just might be the roots of the next big crash.