After Last Week’s Explosive Volatility, are ETFs Really Safe?

In a word, yes.

First you need to understand that the media uses the term “ETF” (Exchange Traded Fund) to describe pretty much any exchange traded mutual fund (believe it or not ETFs are technically mutual funds that are tradable like stocks). ETFs have been around since the early 90’s, but only became highly popular in more recent times – in particular since 2008 when cash poured out of conventional mutual funds, and into ETFs. In the 10 years since, there has been an explosion in the amount of Exchange Traded Product (ETP) that has been introduced. Not all of them are alike. In fact, there now exists a vast spectrum. On the one end, you have the traditional ETF – a plain vanilla basket of stocks tracking an index or a sector. On the other end we now see exotic, and highly synthetic ETPs – including Exchange Traded Notes (ETNs).

Warren Buffett famously called derivatives financial weapons of mass destruction in the aftermath of the Great Recession (2008-09 financial crisis). He was referring to collateralized debt obligations (CDOs) and the largely unregulated swaps markets. The latest financial weapon of mass destruction was linked to yet another derivative linked to options volatility. The VIX index measures the weighted average implied volatility of the stocks in the S&P 500 index. Implied volatility is the key variable in options pricing. Think about it as the premium an insurance adjuster charges a smoker versus a non-smoker. A smoker will simply need to pay more for insurance, so the implied volatility of their life expectancy is higher than for a non-smoker. Futures contracts linked to volatility were, in part, blamed for the most recent “flash crash.”

There are some $2T in assets linked to selling volatility. In normal circumstances, expectations for volatility in the short-run is less than expectations for volatility in the future. This is called the term structure. ETNs were packaged up to play both the long and short side of changes in volatility. I’ve said from the day these products launched: individual investors should not use them. But like most things investing, fear and greed drive the bus. Selling volatility has become a cash machine for Wall Street and the institutions that trade it.

In the melt-up market of 2017, these inverse VIX ETNs that profit from the normal term structure of volatility showed investors returns of 400-700% over the past year – insanity, rivaled only by cryptocurrencies. Those gains were wiped out in a few hours last week, as volatility spiked. As it played out, it forced these ETNs to buy even more exposure – leading to a spiraling spike in volatility. Bottom line is that forced buying or selling almost always causes extreme movements in markets.

The catalyst for the volatility was mainly concerns about late-cycle inflation pressures, and that central banks will take the punchbowl away over the next year or so. Expect higher volatility throughout 2018 compared to the benign year that was 2017. This will offer many more opportunities to take advantage of mispriced assets. While there is a good degree of global economic momentum driving earnings, the headwinds from rising rates will impact the high valuation of equities in the next few years. Another recession is inevitable. It’s always just a question of when, not if. Sitting on the sidelines is dangerous, because missing the final innings of a bull market can be very painful indeed. It’s a challenging time of playing offence and defence at once.

More than ever, it’s time to check your portfolio design and be very honest with yourself about what kind of investor you are. Last week was a wake up call for how you deal emotionally with fear and volatility. This week it seems you have some time to adjust your investment approach if you had a hard time sleeping at night. Do not let complacency set in. If you know you need to make changes, do it now. Whatever you do – don’t let the fear of missing out drive your investment decisions.

In just a few weeks, the latest edition of my National speaking series – The Investor’s Guide to Thriving kicks off. Our upcoming seminar series will help investors actively navigate markets with ETF based portfolios to take advantage of the return of volatility. Register free by clicking here. We ask BNN Viewers to make a voluntary charity donation to support Alzheimer’s research at Baycrest Hospital or Cancer research at the Hospital for Sick Children.

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