Tuesday, February 27, 2007

Short-term Liquidity Risk?

Jim Cramer's post "How the System Failed Us Today" quickly highlights similar observations of ETF activity leading the pack in today's shock event. Cramer suggests buyers weren't able to get into the market quickly enough, which could explain behavior observed in the ETF price to index error.

Although I don't usually agree with Jim Cramer's perspective, his indication of aggressive ETF selling is supported by the data. Considerable analysis of how prices significantly strayed from their underlying index fundamental is necessary. It certainly appears that the market hasn't adjusted to the half-trillion dollars of leverage the ETF market represents, let alone the distinctive behavior it presents in market shocks.

Regardless of China contagin conjectures, the rightful name for 2/27's shock is the "ETF Crunch: Part I"

ETF Liquidity Risk in Market Shocks?

Today's market shock (2/27/07) shows some interesting mispricing error between some of the most dominant exchange traded funds and their underlying indexes.

Looking at the S&P 500, with an index daily return of -3.47:
  • SPY yielded a -3.91% return, off 12.68% from the index.
  • IVV (iShares S&P 500 ETF product) yielded -3.86%, off 11.24% from the index
The NASDAQ ^IXIC returned a -3.86%, while the QQQQ NASDAQ ETF closed -4.11%, representing 6.48% of error from the index.

Finally, the Dow Jones Industrial Average (^DJIA) returned a one-day -3.29% while the mirrored ETF DIA returned -3.75%, representing a remarkable 13.98% error.

What's to explain for this level of mispricing? SPY and DIA showed more than four times the average daily volume, while IVV and QQQQ ran at about 2.8 times average volume. Preliminary analysis suggests liquidity risk factors are to play, combined with probable disruption to normal ETF arbitrage activities. It will be interesting to examine if the arbitragers (who normally exchange ETF for the corresponding securities basket, or vice versa) held back due to expectations of further drops in the index tomorrow.

If so, ETF to index mispricing error may suggest some forecasting value in continued market direction. If not, arbitrage opportunities may extend to smaller investors who pick up the significantly discounted ETFs in shock events like today.


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