The Passive Indexing Trap
The next market crash hasn’t happened yet, but there are two problems forming: leverage and liquidity.
As markets have risen, individuals began to believe that the price trend would continue indefinitely. The longer the rising trend lasts, the more ingrained the belief becomes.
ETF investors have become active investors in a different form. As markets decline, there will be a slow realization that this is something more than a buy-the-dip opportunity. As losses mount, investors seek to avert further losses by selling.
At some point, that reversion process will take hold. Investor psychology will collide with margin debt and ETF liquidity. It will be like striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.
When ETF popularity begins to reverse, it will not be a slow and methodical process, but rather a stampede with little regard to price, valuation or fundamental measures.
Declining prices will trigger margin calls that will induce more indiscriminate selling. The redemption cycle will cause catastrophic spreads between the current bid and the asking price for ETFs. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines that will leave investors watching years of capital appreciation vanish in moments.
In 2008, it happened to Lehman investors. Over a 3-week period, investors lost 29% of their capital; over the entire 3-month period, they lost 44%. This is what happens during a margin liquidation event. It is fast, furious and without remorse.
Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But that should be warning enough.