It's time to talk about Heisenberg's Labradors again.
A long-standing position of mine has been that ETFs can't possibly be more liquid than the underlying securities.
That assessment is almost tautological. It's an appeal to common sense. And it's been variously echoed by the likes of Carl Icahn and Howard Marks.
For those who might not have read Marks' missive on this a couple of years ago, here's what he said (my highlights):
ETF's have become popular because they're generally believed to be "better than mutual funds," in that they're traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. "If you're considering investing," the pitch goes, "why do so through a vehicle that can require you to wait hours to cash out?" But do the investors in ETFs wonder about the source of their liquidity?
Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell. Their actions theoretically could cause the trading price of the ETF to diverge from the value of the securities in the underlying portfolio. To minimize that risk, the creators of ETFs established a mechanism through which financial institutions can trade in wholesale quantities of "creation units" of the fund at NAV.
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.
And as a refresher, here's what I said about that exact same dynamic earlier this year (this is a long quote, but I think that's probably ok since, well you know, since I wrote it):
What [Vanguard's report on ETFs] basically says is that in the event there's a lot of selling pressure in a particular ETF causing the shares to trade below the supposed value of the underlying assets (in this case bonds), broker-dealers are going to arb away that difference by buying the ETF shares at a discount, exchanging them for those underlying assets, and (implicitly) pocketing the spread.
Do you see a conceptual problem with that? I say "conceptual" because again, I'm not an ETF sponsor, so I'm not here to try and do a deep dive into the technicalities of this and/or try and quantify the extent to which this mechanism works on a daily basis. I don't care about that because obviously, I'm not talking about what happens on a daily basis. I'm talking about what would happen should something go wrong. When we start thinking in those terms, what was merely "conceptual" very often becomes reality.
So with that in mind think again about this statement from the Vanguard report:
- When falling demand for the ETF shares causes them to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange for the underlying securities.
As I put it a few weeks ago in "'How Do You Sell It?' Vanguard Misses The Point On ETFs": "I'm not entirely sure how willing broker-dealers would be to arb this in a panic."
I mean think about it: would you want to try and arbitrage that disconnect if it meant taking on the balance sheet risk associated with exposing yourself to the underlying bonds? Probably not.
If you've followed my series of posts on this subject, you know the primary target of my criticism is high yield funds like the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK).
These are especially problematic because the junk bonds that underpin them are likely to be the least liquid securities you can think of in a crisis for obvious reasons (hint: they aren't called "junk" bonds for nothing).
This problem is compounded by the fact that a quarter of the float of HY ETFs is held by portfolio managers who are using those ETFs to meet daily liquidity needs. Here's Barclays (my highlights):
On average, 54% of fund flows are "diversifiable," meaning that portfolio managers can reliably use ETFs instead of trading bonds to satisfy a significant share of their own fund flows. Indeed, an analysis of the magnitude of fund flows at the fund level suggests that approximately 25% of the outstanding float in high yield ETFs could be held by portfolio managers with daily liquidity needs. Several pieces of evidence support this view (alongside anecdotal evidence from money managers and ETF traders). The first is the high concentration of assets among passive high yield funds. The top three passive funds represent 68% of passive high yield assets, while the top three passive government and equity funds represent 39% and 16% of passive assets, respectively. All of the large passive funds in high yield are ETFs, which have the benefit of trading in the secondary market. High concentration leads to larger secondary flows, which is useful for institutional managers trying to use ETFs to manage inflows and outflows.
The passive share of high yield fund AUM can therefore be thought of as comprising two different types of owners: retail investors that own ETFs as part of their investment strategy and institutions that use them primarily for liquidity management. Secondary flows from the first group are not replacing corporate bond trading - they are similar to gross flows for an open-end mutual fund, which are netted at NAV. Secondary flows from institutions, however, may be replacing trades in the underlying corporate bonds.
This is an important differentiation, because the overall flows for high yield ETFs are large relative to the size of the high yield market, despite the relatively small size of the funds. Daily TRACE volumes in high yield bonds averaged $12bn last year. Secondary trading in the four largest high yield ETFs, which represent only about 3% of total high yield assets, was $1.6bn daily in 2016. The contrast in turnover is striking: we estimate annual turnover of about 1.4x for high yield, while the ETF numbers imply annual turnover of 10.7x. Secondary ETF volumes are so significant that, if they were fully substituting away from secondary corporate activity, the implications for bond turnover would be substantial. Figure 7 divides total secondary ETF volume by the size of the high yield market to convert those volumes into a turnover-equivalent measure.
You'll note that this a particularly timely topic given the exodus we saw from HY funds following crude's 10% collapse earlier this month.
Specifically, we saw one of the largest outflows in history:
The obvious question here is whether the mechanism that ensures NAVs don't deviate materially from the underlying assets can be trusted. Because as I noted on Thursday, should some exogenous shock like say, oil plunging to a 30-handle, cause HY spreads to blow out and HY fund flows to accelerate commensurately, this mechanism will be stress tested.
Well according to a new note out from Goldman, HY ETFs are indeed up to the challenge. To wit (and this is important):
In a continuation of a trend that started a few years ago, the volatility of HY ETF flows has further increased in recent months as shown in Exhibit 4. By contrast and as shown by Exhibit 5, the NAV basis, the difference between the ETF's price and the net asset value of the underlying bond portfolio, has been moving within a tighter range vs. the period from 2010 to 2013.
The relatively low volatility of the NAV basis in the face of increasingly volatile flows suggests continued efficiency gains in the mechanics of ETFs. These efficiency gains essentially allow the ETF price gap vs. NAV to close relatively quickly even as the flow volatility moves higher. As we discussed on previous occasions, the rising volatility of ETF flows reflects a higher velocity in the ETF create/redeem mechanism, the process that allows ETF managers and authorized participants to minimize the ETF's tracking error. This higher velocity, a byproduct of more aggressive liquidity provision and improving technology, shortens mispricing periods and thus pushes the volatility of the NAV basis lower. We expect ETFs will continue to capture increased activity, especially as they have demonstrated their ability to withstand volatility flows.
I'm going to oversimplify here because again, I think that's the best way to look at this issue. Put differently, I think Goldman is making the same mistake as everyone else - namely that they're missing the forest for the trees.
The idea that "higher velocity" and "technology" will somehow change the fact that the underlying bonds are illiquid is dubious. This mechanism might be working ok now, but if things get bad enough and flows become unidirectional enough (i.e. completely undiversifiable), someone, somewhere, is going to have to transact in the actual underlying bonds. And that market is getting more illiquid by the day.
I think perhaps the best way to demonstrate the flaw in Goldman's analysis (which essentially says you can fix a flawed model with high volume) is to harken back to a classic Saturday Night Live sketch ca. 1988.
The sketch is a mock commercial for a fictional bank called "CitiWide Change Bank." It's a series of customers explaining how the bank met their needs by exchanging one denomination bill for... well ... for change.
Ultimately, the punchline comes when one of the fictional bank's executives says the following:
All the time, our customers ask us, "How do you make money doing this?" The answer is simple: Volume.
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.