Passive Liquidity Squeeze
I was chatting with some online friends about passive indexing and its dangers and we came up with an idea we call the "passive liquidity squeeze". We define the "passive liquidity squeeze" as follows:
Suppose that market participants have X% of assets in passive vehicles and 100-X% in active management, and suppose that X >> 100-X. Suppose that a sharp selloff occurs that causes shares of passive vehicles to be redeemed for the underlying, and the underlying has to be sold into the active management markets. A small selloff of passive vehicles may cause redemptions that exceed the liquidity supply of the active management market, causing the share prices of the underlying to drop precipitously, causing more passive vehicle share redemptions in a positive feedback loop.
Once the prices of the passive vehicle and underlyings are chaotic enough, the authorized participant will cease NAV arbitrage and the price of the passive vehicle would go into free-fall as selling pressure could continue. This would be like a repetition of the 1987 crash, but possibly could last for much longer. Additionally, if an "index fund bubble" survives a passive liquidity squeeze, further passive liquidity squeezes may continue to happen as people continue to pile into passive vehicles.
As an example, taking SPY's holdings:
SPY has ≈ 183 million shares of AAPL
Meanwhile AAPL trades ≈ 1/4 of that amount daily
If SPY redemptions (creating investors cash demand) force APs to sell the redeemed underlyings in the market (to obtain cash to fulfill SPY sell orders), say AP liquidates 10% of SPY's Apple holdings (≈ 20million shares) that would be 40% of AAPL's daily trading volume. This would mean SPY sales -> SPY redemptions -> AAPL sales -> AAPL falls -> SPY falls -> people want to sell more SPY
I just wanted some outside opinion on how likely this scenario could be in the future, say a decade or two out from now, when the percentage of assets in passive vehicles will be even higher than what it is now. I just wanted to make sure we were not all putting our tinfoil hats on and engaging in groupthink, but rather we hope we might be anticipating a risk others might have thought about too.
I'd love to hear your thoughts on this!
The concept of a "passive liquidity squeeze" is not only plausible but has been a topic of concern among market participants and analysts. Based on the most insightful WSO discussions, here are some key points to consider:
Passive Investing's Dependence on Active Markets:
Passive vehicles like ETFs and index funds rely on active markets for price discovery and liquidity. As highlighted in WSO threads, passive investing depends on active participants to ensure that market prices reflect fundamentals. If the balance tilts too heavily toward passive, the market's ability to absorb large selloffs could be compromised, amplifying volatility.
Liquidity Mismatch:
Your example of SPY and AAPL illustrates a critical issue: the liquidity mismatch between the holdings of passive funds and the underlying securities. If redemptions in passive funds force authorized participants (APs) to sell large quantities of underlying assets, the market may struggle to absorb the volume, especially during periods of stress. This could lead to a feedback loop, as you described, where falling prices trigger more redemptions and selling.
Historical Precedents and Risks:
The 1987 crash, while not directly caused by passive investing, demonstrated how feedback loops and liquidity crises can escalate rapidly. Similarly, during the March 2020 COVID-19 selloff, ETFs experienced significant dislocations, with some trading at discounts to their net asset values (NAVs). This highlights the potential for passive vehicles to exacerbate market stress during periods of illiquidity.
Future Implications:
As passive investing continues to grow, the risks of a liquidity squeeze could become more pronounced. WSO discussions suggest that the increasing dominance of passive strategies may lead to less efficient markets and greater systemic risks. However, some argue that market mechanisms, such as circuit breakers and regulatory interventions, could mitigate these risks.
Counterarguments and Mitigating Factors:
Long-Term Considerations:
Over the next decade or two, the likelihood of a passive liquidity squeeze will depend on several factors, including the growth of passive investing, market structure changes, and regulatory developments. While your scenario is not guaranteed, it is a valid risk to consider, especially as passive strategies continue to dominate asset flows.
In summary, your concerns about a "passive liquidity squeeze" are well-founded and align with discussions among market professionals. While the exact probability and timing of such an event are uncertain, it is a risk that warrants attention, particularly as the passive-active balance shifts further.
Sources: Is Anyone Bullish on the Future of Asset Management???, Is Anyone Bullish on the Future of Asset Management???, Is Asset Management shrinking?, Is asset management underrated?, Passive Investing Bubble?
Many stop gaps before a "free fall" would occur - if the market makers fail, there is risk capital that will step in to hold the price. For example, once SPY dips a certain amount below NAV, any active manager (i.e. non-AP) can step in to buy cash SPY and sell e-mini futures, both offsetting the selling flow and earning the NAV spread. Don't need a lot of active management AUM for this, as the trade can be highly levered.
You are right that the larger passive gets relative to active, the more problems of this nature can occur - but would be in the form of actual passive dumping of the underlying asset class vs. some self-reinforcing panic on an ETF NAV spread.
Vel voluptatem quaerat modi aut et. Eum odio doloremque debitis eveniet hic placeat.
Nesciunt velit nihil suscipit cupiditate. Omnis et alias est dolorem. Soluta corrupti quaerat quis provident earum repudiandae.
Ipsa saepe assumenda officia aut officia debitis. Neque reiciendis voluptatem amet autem temporibus. Praesentium saepe ratione iusto laboriosam quis numquam. Aut fugiat in reprehenderit non rerum non.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...