PrefBlog

Tim Shufelt of the Globe penned a great piece on the stability risks posed by ETFs that included some great quotes from “Mark Kamstra, a professor of finance at York University’s Schulich School of Business, who specializes in the study of financial bubbles.”:

Mass redemptions from active funds could quickly reverse, however, if stock pickers start to reliably beat the market. “People chase returns, so if they see active investors doing great, they’ll plow back into them,” Mr. Kamstra said. Which is why it’s odd to hear active managers complain about ETFs skewing valuations, he said. If that’s actually happening, who better than a skilled stock picker to take advantage of those mispricings. “If I were an active investor, I’d be loving that stuff. It makes for opportunities,” Mr. Kamstra said.

Yep. CPD and ZPR are my best friends. However, I was disappointed that the problem of differential liquidity was not discussed in the article – I quoted the following on August 22, 2014:

The WSJ points out:

While it’s important to look at how ETF shares are trading, the fund’s underlying holdings are really the heart of the liquidity issue, experts say.

One reason: Big investors known as “authorized participants” can swap a basket of the fund’s underlying holdings for ETF shares—or vice versa. This process helps arbitrage away significant gaps between the ETF’s share price and its NAV, the value of its underlying holdings. But when the underlying holdings are costly to trade and tough to obtain, authorized participants are less willing to round up that basket of securities. That means big gaps can develop between an ETF’s share price and its NAV.

One place to watch out for these premiums and discounts is in bond ETFs, especially those focused on areas like corporate investment-grade and high-yield, or “junk,” bonds. The iShares iBoxx $ High Yield Corporate Bond Fund closed within 0.5% of NAV on only four days in the fourth quarter, iShares says, and traded at a premium as large as 2.1% in that period.
…
When underlying holdings are traded less frequently, or not at all, an ETF’s returns also may diverge from the benchmark it is designed to track. That became an issue for some bond ETFs recently as the Federal Reserve bought up large quantities of agency bonds and mortgage-backed securities, essentially removing them from the market. Vanguard Group recently changed some of its bond index funds and ETFs to benchmarks that exclude these securities purchased by the Fed.

The biggest test of bond-ETF liquidity may be yet to come. So far investors have poured money into these products, and many bond ETFs are trading at significant premiums to NAV. But if investors reverse course and stampede out, the trading could get ugly, experts say. Given the relative illiquidity of many of the underlying bonds, the ETFs could start trading at significant discounts to NAV.

“When everybody tries to get out, it’s going to be a debacle,” says Scott Freeze, president of Street One Financial.

Don’t get me wrong – I think ETFs serve a great purpose and particularly recommend them for retail bond investors. But when you have a liquidity inversion – the ETF being more liquid than all (or even just some) of the underlying assets put together – you face huge problems in that ETF cash flows can overwhelm the cash market, which will lead to galloping, self-reinforcing price trends.

Does anybody remember the financial crisis? A big part of the problem was the AAA tranches of sub-prime-mortgage-backed securities. There wasn’t really anything much wrong with the AAA tranches – the junk and mezzanine debt got whacked, but the all that happened to (most!) AAA tranches was a downgrade or two (which is why the politicians like to talk about downgrades when criticizing the banks, not actual defaults). But the downgrades caused selling pressure … and nobody wanted to buy … and the world fell apart. And the same think can happen again if you have billion-dollar cash-flows in a million-dollar market.

This entry was posted on Monday, January 29th, 2018 at 7:17 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.