What ETFs, Smart Betas and Flash Crashes have in common
By Irene Aldridge
Last week’s announcement by Goldman Sachs (http://dailyalts.com/goldman-to-launch-etf-based-on-hedge-fund-research) to launch a new Exchange-Traded Fund (ETF) based on their popular hedge fund investing index has created a new wrinkle in the ongoing storyline of automation in investment management. In a nutshell, Goldman Sachs is seeking to replace a host of high-priced hedge fund managers that invest in concentrated portfolios of commonly-held stocks by a low-cost ETF accessible to all investors. In exchange, of course, the Goldman Sachs team will earn a small haircut on a projected enormous population of the consumers of the new ETF.
The appeal of concentrated positions underlying the new Goldman Sachs ETF issue is the so-called “smart beta”: an analytical exposure to market risk with the intent of generating profitability, or alpha. The betas are considered to be smart when the long market exposure (buying the market risk, sometimes on leverage) coincides with the market rising, and the short market exposure is followed by the fall in the market, generating profitability. As this article shows, however, as smart betas proliferate, they become an ever larger force behind market destabilization.
The beta loadings, whether smart or not, tend to be undiversifiable. Due to several factors: ETFs and the statistical arbitrage of ETFs and other asset classes, many securities are dependent on the market movements and move along with the market, whether up or down. As a result, hedging the market beta exposure is complicated and expensive, and many smart beta traders forgo hedging altogether – precipitating and even exacerbating a new financial crisis.
As AbleMarkets analysis shows, flash crashes do not happen instantaneously, but rather develop gradually over hours and even days. At the onset of a flash crash, the prices of individual securities begin to move erratically, much like molecules heated inside a sealed container. If the prices of several securities become agitated, due to the continuous statistical arbitrage, the agitation spreads to other securities, promulgating market-wide chaotic price movements. If the market boiling point is achieved, the prices break out of the container with a massive crash, only to cool off in a matter of minutes and return to their normal state in a few hours.
Most smart betas are too long-term to account for the probability of flash crashes. However, most portfolio managers set stop-loss orders that reduce or liquidate portfolio holdings when the value of the portfolio drops below a certain level. In the cases of flash crashes, the markets recover promptly, leaving portfolio managers with gaping losses in their accounts.
What is the solution to the problem of flash crashes? According to AbleMarkets research, the onset of flash crashes can be detected much in the same way as the human propensity to have heart attacks and other diseases. AbleMarkets has identified certain markers that, like human blood test results, point to whether the markets are susceptible to price agitation, potentially leading to flash crashes.
Of course, like the predictions of human heart attacks, the detection of market crashes is probabilistic and false positives exist. Still, the benefits of understanding the market dangers outweigh the ignorance.
What can investors do when flash crash-ripe conditions are detected in the markets? Hedging becomes a priority, especially for smart beta strategies that bear huge exposure to the markets. Whether futures or options-based, hedging carries a low cost in comparison with the benefit it provides. It is indeed better to be safe than sorry, especially when the probability of an impending flash crash is high.
Irene Aldridge is Managing Director in charge of Research & Development at AbleMarkets. She is the author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (Wiley, 2nd Edition, 2013). She can be reached via firstname.lastname@example.org