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6min chapter
Liquidity Cascades
Flirting with Models
The Market Incentive Loop
The increasing role of passive and index investing may be creating distortions at both a macro and a micro level. This could potentially lead to significant cross sectional in market volatility as crowds pile into a divergent trade. In volatile markets, regardless of cause, there is a dramatic mismatch in liquidity needed versus liquidity available during periods of market stress. For investors with a long enough time horizon, the simplest trade may simply be to apply leverage to their portfolio. While they should expect a substantial increase in short term volatility, the stabilizing effects of the fed will allow them to adopt this leverage with little risk.
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