Index Funds and ETF’s Are Not Like Stocks

I’ve slowly been working through understanding the extended risk of owning a large concentration in index ETF’s and index funds. The narrative goes “you can’t beat the market!!” It turns out ETF’s are not the market. They are derivatives and they are fairly opaque to market risk. The problem is entry, exit, price discovery and congestion. The problem is also the narrative that pretends these are nearly risk free assets ad certainly more risk free than single stocks.

ETF’s tie up your money. The money disappears month after month, year after year after being shoved in the maw automatically with no clear understanding of what is owned, the value of what is owned or the end game on how to get the dough back from the maw. No clear understanding of the financial manipulation and magic associated with these assets. In normal times, no big deal. You don’t know the value but you can write an order to sell and the ETF’s sell because they are liquid enough and your profit is basically determined by a state function . Come the crunch they will not be liquid, and a sale will be forced by illiquidity and robot sales to way below market value.

I saw some recent self proclaimed FIRE blogger “expert” talking about how index funds are safe because they represent such a small portion of the market. I guess he thinks 70% is small. These funds have never represented this level of market weight and nobody knows how they will respond to a crash, but my guess is the volatility will be increased as a power law not in some linear way. A power law for the integer “2” is 1, 2, 4, 16, 64 etc. If volatility is increasing by 2, 4, 16, and not 1, 2, 3, the carnage will be intense… beyond intense.

Included are a series of 3 videos for about 2 hours worth of how to think about your risk

It’s a 2 hour counterpoint to the mantra, when the boggleheads start spreading the BS.

I do not know what is going to happen. The VIX ETF is running 12 as of today. In Nov 2008 it was 62, a multiple of 5 compared to 12, which was the VIX in Apr 2007. ETF’s and index accounted for around 25% of the market in those days, meaning 75% of the market was amenable to price discovery. Today it’s reversed. I think it might be a Pareto principle situation. 80% of the BS is promulgated by 20% of the morons when it comes to risk. And people think Suzie O doesn’t know what she’s talking about.

8 Replies to “Index Funds and ETF’s Are Not Like Stocks”

  1. Hey Gasem,

    I agree that it is likely unwise to use equities as a blunt instrument of force. Investing involves risks no matter how diversified or whichever avenue you choose.

    I have zero idea what is the best approach and thus I will use as many different approaches that I can stomach.

    Some principles generally hold true. Buy low, sell high. Positive cash flow for RE. Lately I have been pleased with guaranteed, indexed to inflation. Live within ones means. Do not take on debt you can not handle. Etc.

    Your writings are a good reminder of other opinions. I think too many are being lulled into believing the money game is truly that easy. Many of us have been smacked too often to be true believers in anything by this point.

    1. Hey MB

      In 2008 we were sold the bill of goods that sub prime was credit worthy. The magic was CDS and tranches of bonds which were supposedly mostly AAA that turned out to be C. Today we are sold a PE that is 1/2 of the real PE as normative and we are sold an index (QQQ) where 40% of the market weight is supported by by 5% of the stocks in the index. How is this diversified? Further in the S&P 500 it’s 40 stocks that support the growth in the entire index. Further the stock prices are manipulated through share buy back which reduces the float and pumps up share price in a somewhat artificial way, especially if the buyback happens because of cheap shaky debt. Corporate debt is 4T in BBB bonds on level above junk. 19% of the S&P’s share price is due to share buyback using debt not from increased business productivity like new factories.

      This is the issue and it is from where the excess risk will arise once growth falters. The reason I published this was to bring some clarity to the narrative.

  2. There’s certainly a sedative quality to investing that can be hazardous – perhaps “set it but never forget it” is a better approach.

    I’d concur with Dr. MB that sending a pair of horses from your stable down several roads make it that much likelier that you avoid catastrophe and eventually reach Dublin.

    I’m skeptical of fundamentalism in religion and investing – to paraphrase Christopher Hitchens, sheep tend to be fleeced and led to slaughter.

    Always better cautious and wide-eyed as you enter a world of risk you must endure.

  3. Never been to Dublin, but I kinda like the music.

    Today I bought a Hedge fund product and I’m going to trade using sector ETF’s in a long/short fashion in real time according to trading rules and and scaling as a means to get some exposure to this hedge fund method in the market. My life will be more complicated but if I can master the technique I stand a chance to side step the freight train that’s coming down the track. Many roads is my belief as well and that now includes an active road because I no longer have faith in the strictly passive narrative. I think we’ve been sold a load. I transferred 100K into a separate trading Roth as a stake and will use that to teach myself the system. Since some ETF’s at FIDO can be traded for free I can scale in and out of positions for free which makes it cheaper to trade than a Vanguard buy and hold. There are short’s and longs on the trading list as well as sectors prioritized for the best shot at return. I use a Roth to eliminate tax liability. If I make more money in the trading Roth over the next year compared to my otherwise optimized portfolio I’ll be adding more money to that Roth next year and the year after. We’ll see what we see.

    I think the risk management inherent in the system will preclude a big loss so I’m not worried about that. In bad times the position is to basically go to cash and or short and side step the freight train and then get back in once the train has passed.

  4. Gasem – I admire your willingness to examine and try other investing ideas. I like the concept of hedging but not sure if I could follow the market diligently enough to try something like this. Out of curiosity, how would you compare this idea to one of your previous posts, using Harry Browne’s Permanent Portfolio as a permanent hedge for a portion of your portfolio?

    1. I compare it both/and not either/or. The HB portfolio is a portfolio of 4 different risks, each of which has its time in the sun. The time in the sun is determined by the economy and inflation, so the map becomes 4 quadrants of paired risks. So in good times and high inflation (quad 1) stocks soar. In good times and low inflation (quad 2) some stocks and bonds soar. In bad times and high inflation (quad 3) TIPS dividend stocks like utilities and Gold soars. In bad times and low inflation cash and maybe gold soars. So Harry Browne is a no brainer kind of set and forget portfolio when it comes to risk management under the 4 pairs of economic/inflation conditions. HB gives a steady predicted about 6% return with very low volatility. The vol is so low you can withdraw more than 4% (like 5%) over 30 years and not run out of money. The problem with HB is you can’t mess with it. If you start screwing around with the returns (like buying 50% stocks instead of 25% in the “good times”) it will clean your clock because there is no trigger to tell you when to go back to 25% and one day you wake up and 25% of your money is gone. A hedge fund product is a bit like a HB portfolio with triggers that tell you how and when to manage your risk. It may also allow you to double your risk in certain asset categories by going long and short in the category so REITS may be on a tear and software is in the dumper buy VNQ and sell IGV. If one of those choices proves wrong and you have 20% allocated your risk is reduced. Let’s say your long VNQ with 6% of your trading money and short IGV with 3% and IGV and VNQ has a big pop, that means part of the 3% goes away lets say to 2% but the 6% stake may go up to 9%. Your net position is up 2% despite the hit on the short. You make 2% over and over across a year and pretty soon you’re compounding to 20%, so this is a kind of active risk management. Your final result is determined by being right more often than you are wrong and by how you scale into being right or wrong, so you may scale 6% as buy 2% buy 2% buy 2% and hold for a while then sell 3% then sell the last 3% as the rate of growth decelerates. You get out at rate of growth deceleration, not stock price decline. By time decline hits you are long gone.

      The trigger is the second derivative of the growth curve when that growth inflects and the sign changes from + to – you may still grow for a while but rate of growth slows or ceases. If it’s buy low sell high you buy at the low end of the range (which is when the inflection goes from – to +), sell at the high end of the range (when the inflection goes from + to -. If you short stocks you can then short when you hit the high end and ride it down till it hits the low end. So it uses a HB like multi risk technique but one which is dynamic not static. The technique if you precisely follow the rules is low risk because it’s designed to win considerably more often than loose. The ranges and buy and sell points are quantitatively and mathematically determined based on probabilities and based on today’s data. Tomorrow’s data may tell a different story, so the process is market driven not opinion driven. The real courage comes in believing in the data and the model.

      Nobody told me about the risk associated in buy and hold ETF’s and mutual funds. I had to ferret that out myself. Boggleheads and JL Collins and WCI are all telling me there is no no no risk. Clearly they are squawking agenda and narrative and are either lying or ignorant or simply interested in selling books and advertising in their businesses. They clearly give 2 shits about my fortune or yours or anybody else’s fortune except their own and for me that’s not good enough.

      It doesn’t mean I’m doing a bang bang on my style. I still have many million invested in various assets which are optimized according to the efficient frontier, but it’s clear there are a set of risks in the EF calculation that does not include the behavioral aspect of investing namely the associated narrative (4 x 25 for example) nor does it include the risk involved in hopping up the numbers with share buy backs using barely sustainable debt, screw ball financial calculations and massive leverage.

      2008 was about hidden risk. It was about cabbies buying McMansions 2 new cars and a boat using leverage and pretend + credit ratings. It was blamed on Goldman but it was the “little guy” who readily engaged in the delusion and once the delusion popped put the keys in the mailbox and walked away leaving the FED to bail them out. I saw the delusion in 2007 but wasn’t smart enough to articulate an adequate response to what I saw coming. I didn’t consider the moral hazard and just figured people would loose the property and lenders would go bankrupt. Forewarned is forearmed. This time I’m doing something to protect myself and possibly even make some money. I see the risk now to be far greater than the risk then, and the “stupidity” to be far more willful, in fact intentional. If I can figure out a rational strategy of protection I will use it to protect myself and my family, and I will write about it.

      I’ve recently resigned pretty much from the FIRE community. I was on PoF Facebook sites and doing some mentoring but in good faith I can’t push some investing technique, I no longer see “safe”, as safe. I’m not sure exactly what is safe, but I am sure the bogglehead approach is loaded with hidden risk covered over with over simplified folksy narrative. I don’t think the bogglehead is entirely wrong, I think it’s a matter of correct sizing of risk, leverage and asset allocation in the face of current macro economic conditions, which includes huge government debt, underfunded pensions, underfunded SS, BBoomer retirement which will result in thousands of portfolios undergoing deflation, and a big decrease in accumulation in index funds, huge and unsustainable corporate debt, Millennial’s who are underwater out of the gate so they won’t be buying boomer McMansions any time soon, what looks to be world wide deflation as population aging reaches all time highs across the planet while birth rates reach all time lows. Early retirement and drug abuse (pot and all that) will exacerbate this situation due a huge loss in productivity.

      I read a book on fractal math last week. It turns out risk has associated a second order variable multiplier. That means you fail slowly and then all at once. I don’t mean to scare anyone with my negativity, I may be completely wrong. It’s Paschal’s wager. If I’m wrong I’ll have plenty of money if I’m right I’ll have a chance.

  5. Sounds like you are signing up for an additional degree, not just a set on investing skills. If anyone can pull off the complexity and assess the risk, I have faith that you are that guy.

    Look forward to your reports from the front line.

    1. I’ve put in a good bit of analysis for sure. I have a history of successful trading in the past but it’s a lot of work. You can win at black jack, you just have to count the cards, know how and when to bet, and spend 10 hours at the table playing the game. I used to day trade trade stock options back in the 90’s and I traded commodities futures back in the 70’s so it isn’t my first rodeo. Given the way the notifications are set up it shouldn’t be too bad, I should be able to do it on my phone. I haven’t quite figured out the scaling yet. I place 2 trades today just to get the feel GLD and XLE. I don’t know how to go short in my particular account. I tried but wasn’t able to get the job done. If I can’t short it will be OK there is just more to be made if you can. It will be good enough for me to get an idea of the validity of the system and then I will be able possibly to convert to a long/short account. My cost for the trades I made was ZERO basis points at FIDO and it’s Roth money so no tax on the profit.

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