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posted on 08 September 2017

The Risk To Passive

Written by , Clarity Financial

There are risks in passive investing; a potential danger was noted by Bryon Wien in the form of ETF’s (Exchange Traded Funds). To wit:

“One other potential danger that investors seem too complacent about is Exchange Traded Funds. While most know these instruments as a great convenience in getting or reducing exposure to sectors or asset classes, they may prove to be less liquid than their participants believe and could destabilize the financial markets."


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But most importantly:

“Most owners of ETFs don’t know what’s in them. What happens when everyone wants to get out at the same time?"

As I noted in “Rise Of The Robots:"

“At some point, that reversion process will take hold. It is then investor “psychology" will collide with “margin debt" and ETF liquidity. As I noted in my podcast with Peak Prosperity:

‘It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.’

When the ‘robot trading algorithms’ begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

If you don’t believe…just go look at what happened on September 15th, 2008.

It happened then.

It will happen again."

While investors insist the markets are currently NOT in a bubble, it would be wise to remember the same belief was held in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious" to everyone. Of course, by that point, it was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:"

“While the temptations are great, and the pressures strong, illusions in numbers are only that - ephemeral, and ultimately self-destructive."

But it was Howard Marks which summed up our philosophy on “risk management" well when he stated:

“If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk."

I will receive a lot of emails from this article trying to pose counter-arguments, explain to me why this time is different, or that I am missing out.

I am okay with that.

Client’s don’t pay a fee to chase markets. They pay a fee to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

So, what’s your plan for the second-half of the full market cycle?

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