Icahn, Rusty Markets, And The World's Largest Asset Manager

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The world's largest asset manager reported earnings on Friday.

I imagine Carl Icahn is somewhere shaking his head.

Let's think about BlackRock's results in the context of market liquidity.

One thing I learned long ago is that when it comes to thinking (and writing) about markets, understanding things at a conceptual level is far more important than cataloguing all of the details.

It's true that you'll always need at least some metrics to support whatever broad narrative you construct. But the key is not to get so bogged down in technicalities that you talk yourself out of your own common sense-based conclusions.

Let me give you a prime (no housing market pun intended) example. Once you understand the basics of cash CDOs, synthetic CDOs, and securitization in general, it doesn't take a leap of logic to come to the conclusion that otherwise risky credits do not become safe simply because you pooled and tranched them.

Now sure, the ratings agencies will be happy to explain how they came to rate certain deals AAA, but you don't need to dive into the details of their models to know that in the long run, they'll likely be wrong. As Deutsche Bank found out in August of 2007, even bets involving the super senior tranches can go awry in a chaotic market environment.

One topic that I find to be particularly amenable to the "focus more on the concept, not so much on the mechanics" approach is market liquidity - or, more specifically, the lack thereof.

Two summers ago, we got to watch in real time as one Wall Street titan who understands liquidity at the conceptual level debated another Wall Street titan who, by the nature of his job, thinks about the issue from a more mechanical perspective.

I am of course referring to the now famous exchange between Carl Icahn and Larry Fink at CNBC's "Delivering Alpha" conference.

Icahn essentially accused BlackRock of perpetuating an exceptionally dangerous model by pushing ETFs backed by assets for which the secondary market is exceptionally thin.

Specifically, Icahn suggested that investors in high yield (NYSEARCA:HYG) ETFs have no idea what they're buying and if they should all decide to sell at once, fund managers would have no way to unload the underlying bonds because thanks to the post-crisis regulatory regime, banks are no longer willing to lend out their balance sheets in a crisis. This picture pretty much sums up the conversation:

It's not just Icahn expressing these concerns. Here's a great passage that I like to quote from Howard Marks who also looks at the problem from a kind of conceptual point of view (my highlights):

What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we're back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can't get away from depending on the liquidity of the underlying high yield bonds. The ETF can't be more liquid than the underlying, and we know the underlying can become highly illiquid.

I have of course been over this time and time again (most recently on Friday).

I bring it up again because BlackRock (NYSE:BLK) reported earnings on Friday. Here's a quick recap from Bloomberg (my highlights):

BlackRock, the world's largest asset manager, is hauling in investor cash at a record rate.

There is one issue: the money is moving into low-fee products which track indexes, pinching revenue. BlackRock managed to boost profits in the fourth quarter, though revenue barely grew.

The company's fourth-quarter earnings of $5.14 a share exceeded estimates. Revenue rose 1 percent to $2.89 billion, falling short of analyst estimates of $2.93 billion. Lower performance fees and a stronger dollar contributed to the modest revenue growth.

The firm was a prime beneficiary of a record year in exchange-traded funds. BlackRock attracted $140 billion to its iShares business last year, including $60 billion in fixed-income ETFs.

And from the actual report:

Increasingly diversified groups of institutional and retail clients are using ETFs in their portfolios. This broadening of the ETF ecosystem is creating a deeper secondary market for ETF trading - enhancing liquidity for all investors. iShares generated a record $140 billion of net inflows for the year, including $60 billion into iShares fixed income ETFs, capturing the #1 share of flows globally, in the US and in Europe, and in equity and fixed income. Institutions looked to BlackRock to help them close funding gaps and meet future liability objectives, and we saw record institutional net inflows of $51 billion, driven by fixed income and multi-asset solutions.

So there are two things to point out here. First, BlackRock's revenues are being squeezed by the shift to low cost (i.e. passive) strats. As Bloomberg notes, "over half of the ETF inflows are going to products with an average fee of 0.09 percent or less." Second, investors are continuing to pour money into fixed income ETFs (despite the slowdown in Q4 following Trump's election).

Here are two charts from Goldman that should help you visualize the migration to passive strategies:

(Charts: Goldman)

Shifts of this magnitude don't come without consequences. Although I certainly realize that some of the criticism is to be taken with a grain (or three) of salt given that it often emanates from firms who are losing AUM (and thus management fees) as investor preferences change, I still wonder if Goldman isn't correct to suggest that market efficiency is impaired by falling turnover in the underlying stocks. If they aren't traded as frequently, they can't possibly be pricing news as efficiently and that, as I noted earlier this week, is a problem.

On the second point - the inflows into fixed income ETFs - I would emphasize once again that the more pronounced this trend becomes, the less liquidity there'll be in the secondary market. If the cash market ceases to function and the problem is exacerbated by banks' collective hesitancy when it comes to playing middleman, there will eventually be a day of reckoning.

In the final analysis, I wanted to reiterate the liquidity issue because I feel like putting it in the context of BlackRock's earnings helps to drive the point home.

When you think about all of the above, don't forget to try and look past any technical arguments you might hear regarding why ETFs are a safe and liquid way to get exposure to markets. Think conceptually instead. Imagine you were once quite adept when it comes to playing the piano but have since stopped practicing. If for some reason you were compelled to demonstrate your proficiency on the black and white keys at a moment's notice, do you imagine you'd be prone to making mistakes as you shook off years of rust? Well think about markets the same way. The lower the turnover, the more rust accumulates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.