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In the media in recent months, there were mentions of liquidity risk of index funds and ETFs (sparked by some statements by Michael Burry).

My question is if there is a mass sell off by the public of these index funds and ETFs, and these vehicles are not liquid enough to meet the sell off demand...what actually happens? Does that mean companies like Vanguard, Blackrock, or whichever company my funds are located at...that these companies go bankrupt and I see $0 on my investments?

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Burry's point of view is that passive investing has eliminated price discovery as ETFs must buy all of the stocks in the underlying index. As massive amounts of money flows into ETFs, it also flows into illiquid stocks. He compares this to the inflow into subprime mortgage CDOs leading up to the 2008 GFC where the capital flow was the driving force not security analysis.

He notes that over half of the Russell 2000 and S&P 500 stocks have low daily trading volume compared to the other half and if there is a panic sell off, there won't be enough liquidity (buyers) to take up the volume of shares on the sell side of these lower liquidity stocks. They may crater. This in turn will exacerbate the sell off elsewhere. If it is anything like Black Monday in 1987, B/A spreads will widen, further accelerating the decline.

Is his nightmare scenario likely? The experts disagree but no one knows because we haven't been here before.

I think that the market's circuit breakers will slow the drop but how much is a question mark. Secondarily, the Alternate Uptick Rule will slow the amount of short selling. I also think that the nature of the cause of the sell off will also play a factor. For example, in 2008 the Healthcare SPDR lost 37% whereas the Financial SPDR lost double that (Global Financial Crisis?). It was similar in 2000 when internet and technology were the BIG losers. Or will this potential massive sell off be completely driven by liquidity issues? Again, no one knows the future.

If there is a mass sell off by the public of these index funds and ETFs, and these vehicles are not liquid enough to meet the sell off demand...what actually happens? Does that mean companies like Vanguard, Blackrock, or whichever company my funds are located at...that these companies go bankrupt and I see $0 on my investments?

No, there is no possibility that major market ETFs will go to zero. But a loss of 50% is not unrealistic (see 2000 and 2008) if it hits the fan. Been there, done that and it's possible that it can happen again.

  • I think the major question is, "How quickly will they recover after The Fall?" – RonJohn Jan 19 at 20:22
  • @RonJohn - That indeed would be the major question for those who take the market beating and ride it down to the bottom. For others, not so much. – Bob Baerker Jan 19 at 20:40
  • People who use puts and calls or stop loss orders to get out at the top? – RonJohn Jan 19 at 20:49
  • Getting out at the top is dumb luck. Getting out before the market takes 50% of your portfolio away in 12-18 months is a function of not sticking your head in the sand (money management). Puts, calls and stop loss orders can be part of that. – Bob Baerker Jan 19 at 21:04
  • Or you could just not try and time the market and not have money invested that you may need within a couple years. – xyious Jan 22 at 16:38

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