6 ms·

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you h

by motbob 7y ago

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. The panic of 2007 (or at least, the liquidity freeze part of it) was not directly caused by devalued assets, but rather the fact that banks relied on those assets having a certain value to do basic, short-term lending, and their confidence in that value was blown away. The second concern is not really a concern for long-term investors. Really, neither is the first. Maybe equity is inflated, but where else are we going to put our money? I think that this article is mostly about risk. If you are not too concerned with risk in your investments (which you should not be if you are more than 10 years before retirement, probably), I think this article doesn't say much about what you should do with your money.

bob33212 7y ago
A hedge from this theory would be to buy stocks just outside the SP 500? Something like TSLA. That would be a crazy situation, where the SP 500 is crashing and the rest of the market it taking off
- motbob 7y ago
  I don't know about that. If a general financial crisis is the concern, stocks outside the S&P 500 would not be spared. What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
- ChuckMcM 7y ago
  A simpler option is to buy options on the index. You can butterfly the index with calls and puts around your minimum return / maximum loss tolerance.
  - onaraft 7y ago
    Which requires a margin trading account, a non-trivial amount of trading experience, a non-trivial amount of capital, constant management, and is highly leveraged. The risk profile is totally different.
  - AWildC182 7y ago
    This is the right answer, even if it's a fucking terrible idea.
bgilroy26 7y ago
I think the big moment, if it comes, is when you can envision the difference between how people value the asset in question and how that asset is actually valued. In the case of the housing market, most people in 2003 pictured suburbification and the generation of baby boomer retirement communities as inevitable economic engines. But in the same era, Arrested Development the TV show was skewering over-production of prefab houses and they were closer to the truth. If you could make an analogous case today that the majority of the companies that make up the S&P 500 are over-valued then you could presage the popping of the ETF bubble. In this case, however, the population size of the S&P 500 is much easier to monitor than the population of houses in the US Housing Market, which in 2003 were being built far from Wall Street in pockets of Arizona, Nevada, and Florida. In addition, companies can be subbed in and out of the index with ease in a way that houses cannot pop in and out of the market. That is why I think the housing bubble pop in 06/07 is not analogous to the current era with ETFs
- edmundsauto 7y ago
  Is your suggestion that overproduction of housing is what caused the bubble?
  - swsieber 7y ago
    I could see overproduction of housing as a sign of the bubble. E.g. why are we suddenly giving out more loans?
    - mtanski 7y ago
      New large generation (Millenials) coming to the housing market. Low interest rates driving folks to refinance. New housing is flat YoY if you look at "House Starts" statistics.
  - bgilroy26 7y ago
    It was a lagging effect of the bubble. The 'build anything, people will buy it' approach resulted from people's excessive faith in housing and the widespread idea that prices could only appreciate, which I take to be the true cause of the housing bubble.
nickles 7y ago
> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues. Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF. This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket. These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.
- darawk 7y ago
  I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.
  - nickles 7y ago
    > Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. > ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV Many closed ended funds do in fact trade at a discount to their NAV.

by motbob 7y ago

bob33212 7y ago

A hedge from this theory would be to buy stocks just outside the SP 500? Something like TSLA. That would be a crazy situation, where the SP 500 is crashing and the rest of the market it taking off

motbob 7y ago
I don't know about that. If a general financial crisis is the concern, stocks outside the S&P 500 would not be spared. What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
ChuckMcM 7y ago
A simpler option is to buy options on the index. You can butterfly the index with calls and puts around your minimum return / maximum loss tolerance.
- onaraft 7y ago
  Which requires a margin trading account, a non-trivial amount of trading experience, a non-trivial amount of capital, constant management, and is highly leveraged. The risk profile is totally different.
- AWildC182 7y ago
  This is the right answer, even if it's a fucking terrible idea.

bgilroy26 7y ago

I think the big moment, if it comes, is when you can envision the difference between how people value the asset in question and how that asset is actually valued. In the case of the housing market, most people in 2003 pictured suburbification and the generation of baby boomer retirement communities as inevitable economic engines. But in the same era, Arrested Development the TV show was skewering over-production of prefab houses and they were closer to the truth. If you could make an analogous case today that the majority of the companies that make up the S&P 500 are over-valued then you could presage the popping of the ETF bubble. In this case, however, the population size of the S&P 500 is much easier to monitor than the population of houses in the US Housing Market, which in 2003 were being built far from Wall Street in pockets of Arizona, Nevada, and Florida. In addition, companies can be subbed in and out of the index with ease in a way that houses cannot pop in and out of the market. That is why I think the housing bubble pop in 06/07 is not analogous to the current era with ETFs

edmundsauto 7y ago
Is your suggestion that overproduction of housing is what caused the bubble?
- swsieber 7y ago
  I could see overproduction of housing as a sign of the bubble. E.g. why are we suddenly giving out more loans?
  - mtanski 7y ago
    New large generation (Millenials) coming to the housing market. Low interest rates driving folks to refinance. New housing is flat YoY if you look at "House Starts" statistics.
- bgilroy26 7y ago
  It was a lagging effect of the bubble. The 'build anything, people will buy it' approach resulted from people's excessive faith in housing and the widespread idea that prices could only appreciate, which I take to be the true cause of the housing bubble.

nickles 7y ago

> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues. Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF. This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket. These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.

darawk 7y ago
I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.
- nickles 7y ago
  > Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. > ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV Many closed ended funds do in fact trade at a discount to their NAV.