risks of placing so much into Vanguard?

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bryan
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risks of placing so much into Vanguard?

Post by bryan »

If we assume (because I don't have a source) that most capital invested the markets are allocated to index funds, it stands to reason there is some "risk" there or on the other hand some arbitrage opportunity. I believe there are other threads touching on this so this is _not_ what I was wondering about.

Rather I am interested in a different form of risk, specifically the counter-party risk of having the majority of one's assets in a single brokerage/investment management company. Vanguard is the big dog when it comes to mutual funds and just after BlackRock for ETFs. Not all of these funds are held by Vanguard, of course.

Jacob alluded to (as I read it) a sort of bank run possibility on Vanguard which I haven't been able to understand:
jacob wrote:
bryan wrote:
jacob wrote: Conversely, since so much of the market is now held by just a few companies (e.g. vanguard et al), those companies need to keep cash at hand because in case of mass redemptions, there are now far few people (individuals) left to take the other side. That's the problem with public's lack of strategy-diversification.
hmm, I didn't think it was possible to opt for cash? pretty much only check or Bank2Bank. It's not like vanguard is really in the banking business giving loans or having to keep physical gold or real estate etc?
@bryan - Fund companies will have a checking account with their broker and/or bank just like the rest of us individuals or like other companies. Alternatively, they'll be paying interest to have a line of [revolving] credit. It's not like they have a physical stash in the basement.
As I understand it Vanguard would not be at risk of losing customer funds like banks (which make loans and use forms of leverage). Vanguard does not offer cash redemptions but only Bank2Bank transfers (thereby offloading certain risks). Maybe you could sue Vanguard to get cash..

Perhaps @jacob was alluding to simply the first issue of a market crash versus an actual counter-party risk?

Is there any counter-party risk of using Vanguard brokerage (or funds) to be realistically concerned about? Perhaps their systems would buckle under heavy loads or transactions could be delayed.

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Sclass
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Re: risks of placing so much into Vanguard?

Post by Sclass »

I don't see much risk.

Historically (40 years ago) keeping all your eggs with one broker had issues. The role of the broker has changed a lot in the last forty years. The old stories of brokers selling your portfolio for you or buying you into stuff before asking is so 1970s and before. Or selling covered calls on your portfolio etc. But the brokers then aren't the brokers now. Thankfully this is a thing of the past.

I had an account with Refco before the bankruptcy. I got my money back but it took three years and I missed out on the appreciation of the underlying securities being held. They paid me the cash value of the account on the day of their failure. So even in that situation with a tiny clearing house 1/1000 the size of Vanguard things we're OK. Even without any FDIC protection the disaster got sorted out.

Thankfully Refco actually booked the paper. I guess the other extreme is a place like Bernie Madoff's that is completely phony.

I will think twice before using tiny private clearing houses again. But that doesn't apply to Vanguard.

Disclosure. I closed my account at Vanguard a few years back because it was a traders nightmare working with them. They are more geared to long term investors. Safe outfit.

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Re: risks of placing so much into Vanguard?

Post by jacob »

It's not counterparty risk you should worry the most about. It's liquidity risk due to the increasing lack of strategy diversification in the market.

Remember the flash crash. Contrary to popular opinion that was not caused by algorithms. It was caused by a mutual fund that mistakenly placed a huge sell order on the S&P500 future. Normally most short term liquidity is provided by algorithms which accept your trade, holds it for a short time, and then sell it again. The algos act an an intermediate that connects "real" traders so they don't have to wait 7 minutes or half an hour to find each other. However, when the algos detected the massive order, the correctly saw it as a statistical anomaly and immediately pulled out out the market leaving only other traders. Since the order was so large and "single-minded" there was little demand for the sudden unidirectional supply of stocks for sale. Therefore prices crashes.

That was an example of the risk of putting too much money into the stock-index futures market.

Huge index fund companies face somewhat similar problem. They are long individual stocks and short their own fund shares. (Their customers are short cash and long fund shares). If customers want their cash back, the redeem their fund-shares. The fund company would then have to cancel the fund-shares and sell stocks in direct uni-directional proportion to get the cash to pay their customers.

This is an example of the risk of putting too much money into the stock-index mutual fund market. It is exactly the same dynamics as the flash crash.

The problem for the huge index fund companies is if too many of their customers decide to redeem at the same time. To get the cash, the fund company would then have to try to sell the shares and hope that there are buyers in direct proportion to ratios they are trying to unload. IOW, they need to sell to another and almost equally big index-like buyer on the other side. But wait ... we know that most index like traders are trying to sell. We also know they are in the majority. This leaves a minority of traders willing to buy those stocks. Consequently prices would do their own little flash crash if the fund company tried to sell immediately. (Which they contractually have to).

To avoid this bind, the fund company keeps cash at hand to act as a buffer. This allows them to hand out cash immediately, which they must, and then sell the shares slow and orderly over the next few days as non-index-like buyers appear. It is actually the fund company trying to help their customers from not having their shares redeemed at a price that's 40%-80% below recent market quotes. However, that help comes at the cost of maintaining the cash buffer.

If there was a heavy load sufficient to crash the markets, you can be almost sure it would be investigated by the SEC and post-hoc rules would revert the trades. For example, during the flash crash, all transactions more than n% away from the previous market price were cancelled reverted. However, n% was still pretty high (20 or more). Ditto if a fund company suddenly dumped everything, not only would that be stupid, but I bet it would also be illegal under Reg NMS (a 600+ page legal document describing how one is supposed to trade).

Should you realistically be concerned? Well, Vanguard and a few other megafunds are. This is why they've established the cash reserve. So maybe now you can be less worried about it? Or ponder what other Black Swans might be hiding in the complexities of finance ...

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Sclass
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Re: risks of placing so much into Vanguard?

Post by Sclass »

bryan wrote:Perhaps their systems would buckle under heavy loads or transactions could be delayed.
The delays are why I dumped them.

Their trading room was staffed up with guys who are either really slow or really evil. I never figured out which. I try to believe they blocked my trades to protect me from myself.

So I'll say they are really a good safe place to slowly save a lot of money and slowly withdraw it over retirement.

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Re: risks of placing so much into Vanguard?

Post by jacob »

@Sclass - Back in the days, transactions happened by phone, e.g. you call your department at the exchange. They give it to a runner who physically had to run down to the floor and give it to a trader. The trader would then have to locate another trader in the pit and make the trade. The trader would then send the runner back up with the confirmation slip. Likely they would try to bucket small trades together instead of doing this entire exercise. To prevent brokers from losing money, the spreads and fees were huge. As a result, people could easily take a toilet break, come back, and find that the price hadn't moved.

Electronic trading changed all that. First, the ability to instantly trade instead of waiting for the above meant that people with a modem could trade a lot faster than people with a phone an an underpaid clerk had a speed advantage. They were the first example of high-speed trading. (An earlier version consisted of a trader standing closer to the stairway of the pit so he would get the orders before the others.)

A consequence of each improvement is that fees and spreads have gone down to the point where they are almost non-existent. The downside is that there are often no humans involved in any kind of order making decisions. There are nobody who goes "Wait, what?!?" beyond electronic breakers like "If order size > 500000 then reject" and such.

I'm not overly convinced that the modern system is any better than the old system. It's faster and more precise. I'm not sure it's more accurate.

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Re: risks of placing so much into Vanguard?

Post by bryan »

@jacob ah I think I see now. It seems to me the issue is having mutual fund price determined at end of trading day and a stock exchange that isn't operating 24/7. Thus dealling in futures to create the matching buy order "at market close." Are folks like Vanguard allowed to deal in this sort of thing, anticipating the action at end of day and creating trades during the day to meet demand? Obviously I don't know all the rules and how this stuff works in practice.

Does the increasingly popularity of ETFs help solve this issue? Would explain why Vanguard is pushing them.

I guess it means not much counter-party risk as I thought you meant before. Though it is interesting to guess to what extant MUTF orders can be used by insiders to make profit.

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Sclass
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Re: risks of placing so much into Vanguard?

Post by Sclass »

jacob wrote: There are nobody who goes "Wait, what?!?" beyond electronic breakers like "If order size > 500000 then reject" and such.
.
Actually there are...at least there are at Vanguard. I'd click, then my phone would ring. I knew these humans personally. :? The sad thing is it was such a small department I started recognizing the voice. I was doing things that your typical Vanguarders don't do. Their consumer business is heavily back stopped.

But really this is a completely different thing than you are discussing.

On the larger scale that you're talking about, well, that is interesting and scary given how much money is invested by "indexers". Scary big stuff. I guess everyone with a stock index in their 401k wanted their cash back in 2009. Bad stuff.

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Re: risks of placing so much into Vanguard?

Post by jacob »

When you're buying an index fund you are buying a security that tracks the index. You are NOT buying the index itself. This index is really just a mathematical equation and not a real security in any form. Fund companies allow for some tracking error (google tracking error) but minimizing tracking error is obviously a primary goal because the customers expect the fund to perform like the index as much as possible. How to minimize tracking error is an entire specialization unto itself called basket trading (google basket trading).

It would surprise me if fund companies aren't allowed to deal in the futures market which is open 24/6 (not Sunday) or so, but I don't know for sure.

ETFs are pretty much just smaller indexes, so ETFs spread the trader/investor strategies out a bit (so there's more strategy diversification) but have the same redemption problem although the rules are slightly different. Only certain block traders can redeem ETF shares. You have to be registered and show up with a substantial amount of shares (say 50000) but if you do, you can demand the underlying shares from the ETF company. Consequently there are fairly strong arbitrage reasons to ensure that the price of the whole very closely tracks the price of the sum of the parts.

In general, companies will push whatever products investors are willing to buy whether that be stocks, bonds, ETFs, index funds, active funds, annuities, etc... if you can come up with a new product and popularize it, you got it made.

It's quite ironic that index funds which were intended reduce individual company-risk through diversification of stocks have instead created an index-risk through concentration in indexes. Thus volatility in individual securities have been transferred to the entire market.

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Re: risks of placing so much into Vanguard?

Post by jacob »

Sclass wrote: On the larger scale that you're talking about, well, that is interesting and scary given how much money is invested by "indexers". Scary big stuff. I guess everyone with a stock index in their 401k wanted their cash back in 2009. Bad stuff.
Only for indexers. Not for the few remaining individual investors who took the other side in the most illiquid shares which offered value when their individual prices got systemically depressed. The flash crash was personally good too---I was lucky enough to buy low but not so low that my trades were cancelled.

I should note that a lot of the 2009 down draft was caused by highly leveraged private equity funds dumping everything ASAP. Especially around August/September 2008.

One of the most interesting things of note was how stocks in big indexes reacted immediately whereas stocks in small cap (not in indexes) relied on individual investors to take note and only reacted several days later, always in the same direction. Day traders would have had a field day with that.

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Re: risks of placing so much into Vanguard?

Post by A Life of FI »

Jacob I believe this issue would be avoided if one bought the ETF version of the index - instead of the mutual fund version.

As the mutual funds forms legally require the issuer (Vanguard in this case) to redeem an owners interest in the mutual fund in cash at the end of the day upon the request of any owner of the fund, this can lead to the selling of shares in a flash crash that you describe above.

While most ETF shares (or at least the ones I have looked at Vanguard and other companies) can only be redeemed by certain broker-dealers (not individuals) in creation units (a very large number of shares - i.e., 100,000 shares) and then the redemption can only be in the form of an exchange of the ETF shares for a pro-rata distribution of shares that the EFT holds in its investee companies (i.e. a broker dealer redeeming 100,000 shares in an EFT with a 1,000,000 shares outstanding would receive 10% of the total number of shares that the EFT held in each individual investee companies it owned and no cash).

So the requirement to redeem ETF shares in shares of investee companies instead of cash, would not force (or even allow) Vanguard (or any ETF issuer which did only non-cash redemptions) to sell shares in a flash crash (or any other time) at large losses.

Agree?

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Re: risks of placing so much into Vanguard?

Post by Sclass »

This all sounds very scary.

2009 was really bad for me. Although I did well financially in the big picture, I got scratched up. If I had the choice I would have passed up the windfall to avoid the trauma. The stress of 2009 uncovered my heart defect for one. Well, maybe that was good. ;)

Do you think all the dumb money flowing into the indices is bad like this piece says?

http://www.newyorker.com/business/curre ... he-economy

There seems to be an argument against market efficiency veiled in there. All the participants cannot be rational if they're asleep at the wheel.

Edit - I need to clarify 2009 in my view. I felt like one of those action stars who wins at the end of the film after being dragged behind a car, repeatedly punched, tortured, thrown through some walls and forced to watch his friends killed.
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Re: risks of placing so much into Vanguard?

Post by Tyler9000 »

Vanguard is a good company, but even good companies have some risk. A few I can think of are:

1) Legal problems coming back to bite investors. Consider the lawsuits that have been brought against Vanguard for their fees being too low. Founded or not, those battles do have costs.

2) Securities lending, where the fund you buy is presumably tracking one index, but they lend out your shares behind the scenes to boost returns. Nearly all companies in the financial industry do it, and if you read the fine print they tend to push all the risk onto their customers.

3) Account hacks. Someone stealing your password can cause havoc with your accounts. IIRC brokerages do have insurance for this kind of thing and you may eventually be made whole, but not everyone can afford to have all of their savings locked up while its sorted out.

I've considered splitting my funds between two brokerages just to be safe. The risk is not high enough to make that an urgent thing for me, but it's real enough to make me think about it. I do make it a point to split my funds between different ETF providers (Vanguard, iShares, SPDR, etc.).
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Re: risks of placing so much into Vanguard?

Post by IlliniDave »

Somthing like 30% or so of the market is held in funds that track a small myriad of indices (ETFs and mutual funds combined). I don't know what fraction of those are managed by Vanguard. The largest index mutual funds are of the total market variety. So if there's a mad panic on those that somehow is not caused/accompanied by a mad panic in the other 70% of market participants, then it will put downward pressure on the market, no doubt. I don't see why investing via Vanguard would hold any risks that weren't there for all investors. All mutual funds have the same rules and risks in a panic selloff, whether the portfolio is designed to tack an index or not.
It's quite ironic that index funds which were intended reduce individual company-risk through diversification of stocks have instead created an index-risk through concentration in indexes. Thus volatility in individual securities have been transferred to the entire market.
Actually, traditional mutual were created back in the 1930s for the purpose of allowing small investors to gain enough diversification to avoid excessive concentration of risk in small numbers of stocks. Index funds entered the universe of mutual funds in the mid-1970s to provide broad diversification at the lowest cost and with much less manager risk. I would agree that ETF's seem like they would spread volatility across the entire market (I think the most frequently traded security out there is the SPDR ETF). I would guess the lion's share of all money in US equity index mutual funds are in the combination SP500 funds (stocks of the SP500 index are 75%ish percent of US market cap historically), and the total market indices (virtually all reasonably trade-able stocks in the US), so "index concentration" seems in the aggregate like it's really a broader spreading of capital across the market rather than a concentration.
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Re: risks of placing so much into Vanguard?

Post by Sclass »

Tyler9000 wrote:
2) Securities lending, where the fund you buy is presumably tracking one index, but they lend out your shares behind the scenes to boost returns. Nearly all companies in the financial industry do it, and if you read the fine print they tend to push all the risk onto their customers.

.
Ok, this is the kind of thing I was talking about in brokerages of the past. Of course they all still do it. Old timers (I've read Jesse Livermore) would withdraw certificates to stop this.

But how does the liability fall on the customer (account holder)?

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Re: risks of placing so much into Vanguard?

Post by A Life of FI »

Sclass wrote:
Tyler9000 wrote:
2) Securities lending, where the fund you buy is presumably tracking one index, but they lend out your shares behind the scenes to boost returns. Nearly all companies in the financial industry do it, and if you read the fine print they tend to push all the risk onto their customers.

.
Ok, this is the kind of thing I was talking about in brokerages of the past. Of course they all still do it. Old timers (I've read Jesse Livermore) would withdraw certificates to stop this.

But how does the liability fall on the customer (account holder)?
If the ETF you own lends out securities lends out securities it owns and the securities are not returned due to financial difficulties/insolvecy of the borrowing counterparty - then it is a loss to the ETF which reduces the equity of the ETF thus the share price of the ETF. However I beleive it is relatively common for ETF's to require collateral from the borrowing counterparty equal to the value of the securities to help protect against this risk. You can look in the annual financial statements for the ETFs your interested in to see what their policy is regarding this. From the few Vanguard ones I remember looking at their level of securites lending was relatively low (less than 1% or 2% of total assets) and their policy was to take collateral for the full value all securities loans.

Alternatively if a broker lend out securities you held in your brokerage account with them and the loan wasn't repaid then this loss would flow to the shareholders of the broker first (not you the account holder) and, if the broker became insolvent, and couldn't buy the same securities to return to your account, I believe the brokers own insurance would kick-in to buy the securities and, if this wasn't enough, the I believe the SIPC insurance would kick-in to buy the securities/cover the loss subject to the $500k limitation per account holder.
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Re: risks of placing so much into Vanguard?

Post by jacob »

Sclass wrote: Do you think all the dumb money flowing into the indices is bad like this piece says?

http://www.newyorker.com/business/curre ... he-economy

There seems to be an argument against market efficiency veiled in there. All the participants cannot be rational if they're asleep at the wheel.
Absolutely. I've been making similar arguments for almost ten years now. The problem is not with indexing per se. The problem is with the popularity of indexing. Indeed the problem is with popularity and concentration.

We all know what happens when a single strategy (housing, dotcom, nifty fifty stocks, railroads, tulips, ... and now index funds) becomes popular and everybody proceeds to pile into it. Not to offend anyone although I'm sure it will, but leading with "I have heard the index investing and vanguard is the best so ... " is a sure sign of "dumb money" similar to "I've heard that real estate always goes up and that .. is the best way to finance". BTW, dumb money simply means uninformed which is a technical term for "having no directional opinion". A more euphemistic term would be "strong-EMH money". Basically, it's an investor who does not consider the boundary parameters and secondary effects of their investment behaviour.

Intuitively, piggy-backing is brilliant ... but only when the pig is much larger than the piggy-backer. When the number of piggy-backers approach the size of the pig itself, the pig collapses(*). The idea/sentiment "that there are hundreds of professional analyst teams ensuring that all prices are correct" used to make me laugh but these days they make me want to bang my head against the wall, because in reality in many cases there are only a handful (midcap) or a dozen (bluechip) resulting in maybe only one or two themes which they get from the echo-chamber effect because of course they read each others publications.

(*) The problem is essentially that of a simplifying solution that works well under small changes but which is wrong under large changes. Kinda like how assuming that the earth is flat works well inside of a radius of 100 miles but which has an effect when planning optimal routes over larger distances.

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Re: risks of placing so much into Vanguard?

Post by Tyler9000 »

Fund providers always make the argument that they only lend out securities "in the best interests of their clients", but the ultimate goal is to squeeze out extra profit and they're using your money to do it. The more parties there are between you and your money, the more opportunities for something to go wrong.

Most companies do have fairly reasonable rules about it, but it doesn't make the practice without risk. There's also very little way to avoid it in the index fund space as basically everybody does it. I like to mitigate the risk as best I can by diversifying my fund providers.

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Re: risks of placing so much into Vanguard?

Post by jacob »

@A life of FI - As far as I remember, block redemption also only happen after close (I might be wrong here).

So suppose retail investors began to sell SPY. The price of SPY would then decrease. If the price of the S&P500 components didn't decrease as well, you could arb(*) the situation by buying SPY (low) and selling the the components (which are still high). Then at the end of the day, you take your SPY in for redemption and get the shares you sold to hedge plus extra because you bought low.

In normal operations, this would keep the SPY quotes equal to the appropriately weighted sum of the components. That's how ETFs are supposed to work.

(*) Because this trade is supersimple, it's wired by the fastest infrastructure and hardware. Trades have microsecond latency. The math is run by GPUs and specialized network cards. The exchanges communicate via microwave networks because it's faster than using a satellite beam into geosynchronous orbit. (Of course all this hardware costs lots of money which gets pushed onto investors.)

Now suppose a bunch of people hit the market in a panic with a large number of sell SPY orders. This would cause the SPY price to drop a lot. Not only would it go through the book but buyers would run away or pull out further dropping the price. If this information gets transmitted to the rest of the market (individual stock buyers) thanks to the blinking screens of S&P500 now showing a large drop, arbs would find it hard to short individual shares because buyers of individual stocks vanish too. Zero arbitrage is now gone. The price of SPY is no longer equal to the sum of its parts. SPY keeps dropping but its components are no longer trading. At the end of the day you do the math: if spy < sum(compnents) then redeem, else do nothing. A risk free Taleb like trade would be to short the ETF and long the components and wait for a big crash. Since you're short the ETF you actually get paid the fee while you wait too. Why doesn't individual investors do this? Because of commissions and hassles involved in putting on the trade (imagine trying to blocktrade 500 different companies). Who does this then? Why, ETF companies of course. When they sell an ETF to Mr Retail, they effectively short it and get the fee.

The main difference between an ETF and mutual fund is that in such a situation, the ETF company would go in and buy the ETF whenever it gets too low. This is easier because it's a single product. A mutual fund company would need to basket trade all the components in anticipation of all the cash they have to pay out at closing.

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Re: risks of placing so much into Vanguard?

Post by IlliniDave »

jacob wrote: ... Not to offend anyone although I'm sure it will, but leading with "I have heard the index investing and vanguard is the best so ... " is a sure sign of "dumb money"
No knowledgeable investor that holds index funds would be offended by that if they thought about it. That's really the beauty of the whole thing.

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Re: risks of placing so much into Vanguard?

Post by steveo73 »

IlliniDave wrote:
jacob wrote: ... Not to offend anyone although I'm sure it will, but leading with "I have heard the index investing and vanguard is the best so ... " is a sure sign of "dumb money"
No knowledgeable investor that holds index funds would be offended by that if they thought about it. That's really the beauty of the whole thing.
Yep. My approach is index investing via vanguard ETF's. I still think it's the best approach and it's proven. It might be dumb but it works.

I'm not at all worried about placing my money into Vanguard and I don't think the risk is really any more than putting your money into the stock market via direct shares.

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