Is the tail wagging the dog?

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Grant Wentzel 4 September 2015 Est. reading: 5 min read

The last week of August was one of the most volatile we have seen in global equity markets for several years. The fear that had been building hit the markets with a jolt on Monday 24 August. The warning lights had been flashing for several months but developed equity markets, with the complacency of a boiling frog, had appeared unconcerned by the worrying developments in other asset classes.

Clearly, there were fundamental triggers for the market declines but, in our view, the market moves were exacerbated by flow considerations and market technicals. So, what happened?

What caused the US market to lurch lower so violently and then recover? How could a stock like GE, for example, a $250bn company, fall as much as -21% in the first few minutes of trading and then recover to close the day down less than -3%? Apple, the world’s biggest stock, ‘lost’ $79bn worth of value at the market open but had recovered it all within an hour (by the way, that is broadly equivalent to the entire market cap of AstraZeneca).

First, let’s recap on the fundamental triggers.

Commodity prices had been weak for some time, initially on supply developments but more recent moves lower have been demand driven, signalling a deteriorating global growth outlook, especially in China. Fears about the world’s second largest economy in recent months had spilled over into emerging market currencies, their equities and in to the high yield debt market.

At the same time, the Chinese stock market had become completely detached from the reality of its underlying economy. The fall from its peak in June has been spectacular – in less than 10 weeks, the value of mainland China equities broadly halved, wiping out more than the total capitalisation of the UK stock market in the process.

Chart showing how the Chinese stock market has halved in value, wiping out more than the entire value of the UK stock market

Equities were in the eye of the storm on Monday 24 August after experiencing sharp sell-offs on the previous Friday, when poor China PMI data was followed by weaker than expected US PMI data that afternoon. The weekend press that followed focused on the sell-off and potential implications. “Global stocks suffer rout as fears intensify over Chinese slowdown” was the Financial Times front page on the Saturday.

When Asian markets opened on Monday 24, Chinese equities were hit very hard and closed the day down -8.5%. The falls in China triggered a sell-off in international markets as fear spread across the globe. The moves were extraordinary and have raised a lot of questions about how modern markets function in such volatile conditions. The FTSE was down -6.8% at its low, which coincided with the US market opening on the Monday, but ended the week in positive territory. All European markets experienced similar sell-offs.

Watching the screens at first hand, reading the flood of news on the wires and in talking to fellow traders in the industry, there are suggestions that other forces, besides fundamentals, are at work. Heavy selling pressure in equity futures ahead of the US open certainly played a role in these moves but another significant reason for the market instability and volatility could be trading activity in exchange traded funds (ETFs).

An ETF, or exchange traded fund, is a security that is designed to track a particular basket of assets such as an index, commodity, currency or bond market. They trade like ordinary shares on a stock exchange and are often marketed to retail investors as another form of low-cost, passive investing. There are literally thousands of ETFs which enable investors to gain exposure to all manner of indices, underlying stocks, bonds and commodities.

The ETF industry has grown significantly with assets reaching $2.97 trillion at the end of June. The Economist recently wrote that ETFs have now overtaken hedge funds in terms of assets under management.

They are traded in huge volumes as a separate asset class but some of them no longer resemble their underlying assets. This isn’t an issue when markets are calm but, in volatile conditions and amid high volume, outsized ETFs appear to amplify the underlying market moves. The advent of double and triple-levered ETFs exacerbates this effect even further.

According to Goldman Sachs, over $270bn was traded through ETFs in the US on 24 August – nearly three times as much as usual. There are numerous examples of erratic trading of ETFs in the US and the heavy falls they suffered relative to their underlying assets.

For instance, in the first few minutes of trading, the $5.8bn Vanguard Health Care ETF fell -32% but the value of the underlying holdings fell only -6%. The trading of the PowerShares S&P 500 Low Volatility Portfolio ETF was also somewhat ironic. According to its description, “the fund seeks results that correspond generally to the price and yield of the S&P 500 Low Volatility Index.” In the first 15 minutes of trading, it fell over -45% but within an hour it was down only -2.6%.

Chart showing the return of MSCI US Investable Market Health Care Index vs Vanguard Health Care ETF

Meanwhile, much of the selling at the lows experienced last Monday is likely to have been by US private investors, potentially as a result of automatic ‘stop-loss orders’ triggered when a stock or ETF went through a pre-set stop limit.

An additional problem when markets are falling that fast is that stop-losses would be executed ‘at best’ which can be a significantly lower price than the stop limit. Indeed, several popular retail investor trading platforms experienced technical issues as the panic took hold, causing further delays to pricing and execution.

Ironically, ETFs were, in part, originally designed to satisfy the demand for an intraday trading option from private investors that wanted to trade more frequently than a daily-pricing fund could allow. Clearly they have an important role to play for some investors but it appears their success has brought some unwanted side-effects.

For now, ETFs are a much more powerful force in the US market than they are in the UK. However, their emergence may suggest that we could face greater volatility going forward. More reasons to think long-term, therefore, and to focus on fundamentals, not flow.

This article was updated on 9 September 2015.

Important information

Past performance cannot be relied upon as a guide to future performance.

Over 5 years to 31 August 2015, the returns from the securities / indices listed in this article are as follows:

Security/Index Return (%)
GE 102.5
Apple 247.2
FTSE All Share Index 43.1
Vanguard Health Care ETF 186.3
MSCI US IMI Health Care 25/50 Index 187.6
PowerShares S&P 500 Low Volatility Portfolio ETF 64.6
(since inception 5 May 2011)

Source: Bloomberg on a total return basis in local currency.

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