The market is back. It has certainly been a crazy ride thus far this year. We start up more than 8 percent, then drop 10 percent, and now we are riding back up. A 10 percent correction is normal in long bull markets, but how this one happened was not.
In the aftermath of the recent downturn we have learned more about what caused it, or at least what made it as sharp and quick of a downturn. Many hedge funds that are primarily being run by computers were borrowing money to purchase so-called inverse exchange traded products tracking the VIX, a volatility index sponsored by the Chicago Board Options Exchange (CBOE). These products supposedly produce the inverse, or opposite, return of the index. So if the VIX is up 10 percent, then these products go down 10 percent. Several of these products are leveraged, meaning they will track two or more times the index return. So if the VIX is up 10 percent, these products will be down 20 percent or more.
There are so many things wrong with this it is hard to know where to start. The first issue is the issue of ETF investing in the first place. The first ETFs were based on the S&P 500 index; they are basically index funds, which can be bought and sold any time during the day, as opposed to index mutual funds that can only be bought and sold at market close. Their original purpose was to give institutional investors a place to temporarily park money while transitioning a portfolio from one money manager to another.
Wall Street quickly learned other uses, and like almost every financial crisis in history will prove, bad things happen when Wall Street starts using products for uses other than for what they were originally intended. All kinds of investors started using ETFs, and of course Wall Street started filling that demand with every imaginable flavor. The problem is, most of these products don’t actually work. It is pretty easy to track an index like the S&P 500 – just buy the 500 stocks represented. These are among the largest companies in the world and the market for their stocks is robust so they are easily bought and sold at a moment’s notice.
The further one wanders away from the S&P 500, however, the less true that becomes. Smaller companies’ stocks do not always trade frequently, and it may be hard to buy or sell on demand. The funds that try to track these indexes may not be able to buy all the stocks in the index the moment an investor wishes to buy the ETF. Likewise they may not be able to sell. The problem gets worse for fixed income or bond-related products. Remember, bonds are just loans. A company or a government that needs to borrow money will issue bonds. They only issue the number of bonds they actually need. ETFs and other products tracking bond indexes are often not able to buy the actual bonds, so they buy so-called derivative securities that will hopefully track the index.
The VIX is another problem altogether, because it isn’t real. There is nothing to buy. It is an arbitrary measure of options activity, which the CBOE claims is a good approximation of overall market volatility. Investors buy options to protect against losses in underlying securities. If more people are buying options, then the logic states that they are more worried about loss and therefore experiencing more volatility. In other words, the VIX is more akin to placing a bet on the over/under of a sporting event than it is to an investment. Gamblers – which I’m going to call them, because that is what they really are – develop wagers in the form of derivative products that track the VIX. The ETFs then “invest” in these derivatives. If that makes no sense to you, then welcome to the club.
The final problem with all the ETF-type products is perhaps easier to understand. Index investing is supposed to be passive: just buy the entire market and hold it for a long time. That is the entire theory. However, that is not how people are using these products. A passive investor has no reason to be able to trade whenever he or she wishes because he or she is, by definition, not a trader. These products are being used to trade into and out of stocks faster than ever before in history. The ripple effects mean that prices move more than ever, even when the VIX says volatility is low.
The first fundamental rule of prudent investing is that it is done from the bottom-up. Stock is simply ownership in a company. Investors are investing in companies, not trading pieces of paper. Companies are real; they have real products and services and real revenues and earnings. They have value, and that value adds safety to your investment.
There once was a day when the investment advisory industry was a professional service, helping clients invest for their future. It still is that way at Iron Capital. We will let others buy products, exchange-traded and otherwise. We will stick to investing in things that are real.