Thousands of investors with stop-loss orders on exchange trade funds (ETFs) saw their positions crushed in the first 30 minutes of trading on Aug. 24. Seeing a price blow right through your stop is one of the worst experiences in trading. “What do you mean there was no liquidity at my stop? I got filled $5 below my stop? Wait, now the price is back above my stop.” Welcome to the big leagues.
Aug. 24 was not a glitch. The structural problem here — and the reason this sort of dislocation will happen again, soon and more severely — is that a vast crowd of market participants is making a classic mistake. It’s what a statisticians call a “category error.”
Market makers and the sell side are only too happy to perpetuate and encourage this category error. Virtu and Volant and other HFT “liquidity providers” reportedly had their most profitable day since perhaps the last major volatility spike. So, if you’re a market maker or you’re on the sell side or a business media cheerleader, you call the Aug. 24 price dislocations a “glitch” and misdirect everyone’s attention. Wash, rinse, repeat.
The category error made by most investors is to confuse an allocation for an investment. There’s precious little investing in markets today. Instead, it’s all portfolio positioning all the time. But many still maintain the illusion that what they’re doing is investing, and the business media are only too happy to perpetuate this.
There’s nothing wrong with allocating rather than investing. Smart allocation may be responsible for the vast majority of public market portfolio returns, yet the myth of investing remains. You don’t read Barron’s profiles about great allocators, you read about great investors. We all aspire to be great investors, even if almost all of what we do is allocate rather than invest
The “F” in ETF stands for “fund,” with exactly the same meaning as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your portfolio. Like so many things in our modern world, the ETF is a benefit for the market makers and sell side that has been sold falsely as a benefit for the masses. Investors who would never consider trading in and out of a mutual fund do it all the time with ETFs. Their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.
Aug. 24 was a specific manifestation of the behavioral fallacy of a category error. Investors routinely put stop-loss orders on their ETFs because that is what they are told to do. However, letting winners run and limiting losses is appropriate from a trader’s perspective, not an investor’s. If you’re an investor as opposed to a trader, there’s no good reason to put a stop-loss on an ETF or any other allocation instrument.
An allocation is a return stream with a set of qualities that you believe your portfolio should possess, usually diversification. What does price have to do with this meaning of an allocation? Very little, at least on its own. Are those return stream qualities altered because the price has changed? Of course not. Those return stream qualities can and should only be understood in the context of what else is in your portfolio. It’s not that the price of this return stream means nothing, just that it can’t be measured in a vacuum. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order.
There is a distinction between investing or stock-picking and allocation, top-down portfolio construction, the ecological fallacy that drives category errors and a whole host of other market mistakes. Why is it important? Because this category error goes beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the driver for portfolio allocation decisions and it accelerates the casinofication of markets. This is a tragedy for investors, a wash for traders and the gift that keeps on giving for market makers and the sell side.
Why is it important? Because there are so many investors making this category error and they are likely to continue to get run over by the traders who are dominating these casino games.
A maxim of trading is to take what the market gives you. Right now the market isn’t giving much. That’s O.K. But what’s not O.K. is to confuse what the market is giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology.