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Beware of the ‘Ponzi funds’ that are hiding in plain sight, says strategist
Steve Goldstein
6 min read
New investors can pay for the gains of previous investors when illiquid ETFs surge in value. - Getty Images/iStockphoto
It was a lot more beat than raise from Nvidia in the chipmaker’s third-quarter results released late Wednesday, though there was nothing in the report to suggest that artificial-intelligence mania is anywhere near an end.
There’s a lot of talk of bubbles at the moment — AI, crypto, media companies owned by a particular politician. Joachim Klement, head of strategy at Liberum in London, offers a cautionary tale about the rise of exchange-traded funds. Some, like the ones that track the S&P 500, are broadly diversified and liquid. But many other ETFs are not — they’re thematic and invest in just a small number of specialized companies.
Klement draws on a research paper written earlier this year, with the very blunt title, “Ponzi Funds.” In that piece, authors Philippe van der Beck, Jean-Philippe Bouchaud and Dario Villamaina find a feedback loop, from ETFs to stocks, and then back to ETFs. “Investors are unable to identify whether realized returns are self-inflated or fundamental. Because investors chase self-inflated fund returns at a high frequency, even short-lived impact meaningfully affects fund flows at longer time scales,” they say.
The researchers are quick to emphasize that the ETF providers themselves are not operating literal Ponzi schemes as defined by the U.S. Securities and Exchange Commission. But they note that Archegos Capital Management — where Bill Hwang was just sentenced to 18 years in prison — was an example where returns from an investment fund trading concentrated positions can be driven by the fund’s own activity. And they say that, like Ponzi schemes, “the wealth reallocation from self-inflated returns unravels once the price impact in the underlying securities reverts and investors stop misinterpreting self-inflated returns as managerial skill.”
The researchers point to one “large thematic ETF” with a chart that is strikingly similar to the Ark Innovation ETF ARKK, where its raw daily returns and flow-induced trades were over 40% correlated. Its positions were 20 times larger than the daily dollar volume in those securities, they said. That resulted in situations where the fund was buying 20% of the daily volume of the underlying stocks and stirring that feedback loop.
For illiquid funds, flows determine the returns, researchers find. - Van der Beck/Bouchaud/Villamaina
The issue is not limited to Ark. The researchers looked at 1,868 exchange-traded funds. “When the funds hold a liquid portfolio, there is virtually no relationship between daily flows and returns. However, for the most illiquid funds, the realized return increases monotonically with the flow,” they say.
These funds do typically devour themselves, but not right away. “On average, bubble ETFs do not crash within the first year of the run-up,” they say.
Granted, bubbles have come and gone, but Klement sees something different now.
“But what I think is different with these ETFs is that in the past, investors would likely have focused their thematic investments on one or two of the largest stocks exposed to a theme. These stocks are better able to handle the flows without seeing significant price distortions. In the world of thematic ETFs, more money gets funneled into smaller less liquid stocks in the name of diversification,” he says. “And the more highly concentrated and illiquid ETFs are created, the more likely it will be that these bubbles in small cap stocks develop,” he adds.
The market
U.S. stock index futures ES00 NQ00 shook off early losses to turn higher. Gold GC00 and oil CL00 were rising.
Key asset performance
Last
5d
1m
YTD
1y
S&P 500
5917.11
-1.14%
2.06%
24.05%
29.86%
Nasdaq Composite
18,966.14
-1.38%
3.77%
26.35%
32.95%
10-year Treasury
4.397
-4.60
18.00
51.61
-1.50
Gold
2672.1
3.95%
-2.79%
28.97%
34.18%
Oil
69.87
1.82%
-0.65%
-2.05%
-9.05%
Data: MarketWatch. Treasury yields change expressed in basis points
Jobless claims fell 6,000 to 213,000 in the week ending Nov. 16, while the Philadelphia Fed manufacturing index turned negative in November. Existing home sales data is due out after the open.
All aboard! Vanda Research, which tracks retail investor activity, shares this chart showing the explosion in retail net purchases of MicroStrategy MSTR, the company that sells stocks and bonds to fund purchases of bitcoin. “As regular readers know, our preferred way to navigate these meme stock bubbles once they’re already in motion is to wait for a momentum reversal in retail flows, as that often coincides with significant loss of momentum at the price level too,” they say. But they say that overall retail speculative activity is still not as widespread now as during the peak meme-stock era.
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