ETF Transparency And Liquidity Are Welcome In Stressed Markets

by: Henry Cobbe, CFA
Summary

The shift from mutual funds to ETFs is a secular trend.

Claims that ETFs won't work in down markets are loaded and obtuse.

Active asset allocation - using direct securities, funds or ETFs - is key to managing risk.

Transparency and liquidity of ETFs makes them a useful tool for implementing asset allocation decisions.

The phenomenal rise in ETF adoption looks extraordinary. But viewed in the context of any technology upgrade – from tape to CD, from CD to MP3 – there’s nothing outstanding about it. It’s just common sense.

ETFs are just a more flexible and lower cost way of getting exposure to an asset class relative to traditional mutual funds. Whilst some vested interests in the active world murmur about “How might ETFs cope in market distress?” The answer is, repeatedly (including in recent market stress), “Just fine, thank you”.

Born out of crisis

Indeed, the massive switch from mutual funds to ETFs is in part a direct result of the Global Financial Crisis.

In the GFC, some investors were caught out by 1) not knowing exactly what was in their fund and 2) not being able to sell funds they no longer wanted to manage their risk exposure because they were “gated”. We’ve seen similar gatings of property funds after the Brexit vote, and of bond funds in the face of interest rate rises.

The two greatest benefits of ETFs are, in my view, their transparency (knowing exactly what’s inside the fund on a daily basis, and how it’s likely to behave) and their liquidity (there’s a secondary market in ETFs via the exchange, which means you can buy or sell an ETF without necessarily triggering a creation/redemption process within the fund).

Transparency enables a more precise way of accessing specific asset class exposures. Liquidity is not just about intra-day trading, it’s more about the simple fact that if you don’t want to hold a fund anymore, rather than relying on the goodwill of the manager to accept your redemption order, you can simply sell it via the exchange. This simple difference is a key advantage of ETFs.

Secondary market

Take the high yield bond market. So in a rising rate environment, if investors wish to sell high yield bonds, with mutual funds the manager has to sell the underlying investments (putting further pressure on price and liquidity); with ETFs, the manager can simply sell the ETF to another participant willing to come in at a level that is a bargain for both. The underlying investments need not necessarily be sold. Liquidity is only ultimately as good as the underlying asset class. But in every bond market jitter (including last week’s), bond ETFs have continued to function and enabled liquidity.

I prefer to turn the question on its head: what product do you know of (aside from a mutual fund) that you can only sell back to its vendor? I’m struggling for examples: just a quick look on eBay is enough to show that there’s a secondary market in pretty much everything, be it vintage newspapers, matchbox cars or antique furniture. A quick look on the London Stock Exchange shows there’s a market for pretty much every type of fund: global equity, UK value, UK gilts of different maturity buckets, corporate bonds of different investment grades, gold, commodities, property; you name it, you’ll find it.

It’s asset allocation that counts

Furthermore, I’ve never bought the argument that “ETFs only work in a bull market”. Sure, equity ETFs do well in a bull market, but there are ETFs for each asset class that could be in favour at different stages of the cycle. ETFs are a portfolio construction tool to reflect a desired asset allocation. If you only want high quality, dividend-paying equities, there are dual-screened income/quality ETFs. If you don’t want equity exposure, there are bond ETFs. If you don’t want long-duration bonds, there are short-duration bond ETFs. If you want a cash proxy with a bit more yield, there are Ultrashort Duration Bond ETFs. So ETFs don’t perform better or worse at different times in the cycle. Managers can perform better or worse by getting their asset allocation right. ETFs are just a straightforward way of managing a multi-asset portfolio.

From closet index to true index

ETFs are by definition the commoditisation of the mutual fund industry (standardised formats that can be bought and sold at a published price). The plethora of index rules are the systemisation of the investment process: whether your philosophy is traditional (cap-weighted), momentum, value, small-cap, income, or quality, there are now indices for most investment styles for most asset classes in most regions. The investor’s toolkit has become smarter, cheaper and more flexible. What’s not to like? Given the large number of closet index funds out there, we can expect a continued switch from closet index to true index to drive ETF adoption yet higher. In the meantime, if anyone knows of an eBay for old mutual fund holdings – please let me know.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk