The ETF industry is
now worth more than $4 trillion, magnifying the risk if the funds run into
exchange-traded funds have hit multiyear highs as some investors question
whether this industry—which grew rapidly in the bull market—could handle sudden
redemptions in a downturn.
shorting the shares of some ETFs that buy securities like high-yield debt,
which may be hard to sell if markets turned suddenly, a fear stoked by
increased volatility this year.
The ETF industry is
now worth more than $4 trillion, up from below $1 trillion in 2008, raising its
importance in the global financial system and magnifying the risk if the funds
run into difficulties.
analysts point to relatively recent episodes, like the rise in spreads on
high-yield bonds in 2015 and 2016, as proof that ETFs can manage periods of
“It’s going to get
pretty interesting here with the Fed proceeding with interest rate hikes. You
have a 30-year bull market in fixed income and people aren’t used to what
happens if there’s a downturn in that market,” said Daniel Gallagher, a former
commissioner of the Securities and Exchange Commission and currently chief
legal officer at pharmaceutical company Mylan.
ETF shares are
created by so-called authorized participants—broker dealers who buy the
securities that make up an index tracked by a fund and exchange them for new
When investors want
to redeem their shares, the process works in reverse and the ETF must sell the
securities. If market liquidity tumbles, some investors worry that the funds
won’t find buyers for those bonds.
“Liquidity can be
the next trigger of a crisis. Trust in the instruments of the market can be
questioned, especially with so much leverage,” said Vincent Mortier, deputy
chief investment officer at Amundi, Europe’s biggest asset manager.
Others argue that
corporate-bond ETFs already have fared well in volatile markets. Shelly
Antoniewicz, senior economist at the Investment Company Institute, points to
stresses in the high-yield market in late 2015 driven by tumbling commodity
prices as an example of their resilience.
Between June 2015
and February 2016 spreads on U.S. high-yield debt almost doubled to 8.7
percentage points from around 4.5 percentage points. But even as spreads
jumped, Ms. Antoniewicz notes that redemptions were limited and secondary market
trading of the ETF shares rose, providing additional liquidity to the market.
of the depth of the credit market offer a mixed picture. Average daily trading
volumes have only risen in recent years, ticking above $30 billion in 2017, nearly
double their levels before the financial crisis.
inventories of corporate bonds have fallen precipitously, from as high as $250
billion ahead of the financial crisis to less than $30 billion today.
The prospect of a
liquidity mismatch between an ETF and its underlying investments has also
raised questions about the credit lines often extended by a syndicate of
lenders to some ETF sponsors.
If the assets held
by an ETF are seen as too illiquid to sell, managers could instead tap the
credit lines available to cover redemptions, in the hope that volatility
subsides and underlying assets can be sold at more reasonable, reliable prices
But that logic
depends on the volatility subsiding, and prices rising—otherwise, existing
investors are left footing the bill for the tapped credit line.
“When you have a
liquidity event it’s like squeezing an elephant through a keyhole,” said Mike
Thompson, president of S&P Investment Advisory Service.
“We keep a cash
reserve for precisely those events. I would hate to have to rely on a line like
that, that’s why we have the 2% reserve,” he added.
The SEC ruled in
2016 that mutual funds must implement programs to manage and report on
liquidity risk from December this year, but many ETFs received exemptions.
Amundi’s Mr. Mortier
raised the use of credit lines as a specific risk when it came to liquidity.
“There can be a snowball effect, and we refuse
to do it. It’s becoming a very big issue,” he added. “It’s a strange way to
treat existing investors because you then need to reimburse the loan.”
In 2017, a report by
the Financial Stability Board noted that while credit facilities could reduce
financial stability risks, they could also act to raise leverage on already
distressed funds and increase the threat of contagion to the wider financial
“[A credit line]
clearly helps smooth out illiquid markets. My concerns would be if it was
prolonged and significant. No one can read the markets so it’s a bet on liquidity
and more stable markets returning—which may or may not happen,” said Hector
McNeil, co-CEO of ETF provider HANetf. “My other issue is that the risk is
ultimately shouldered by the legacy holders of the ETF—the ones who have
redeemed are safe.”
Many advocates of
ETFs still see significant advantages to their structure when compared with
other funds and investment vehicles.
“With an ETF you don’t get penalized for
removing money during a specific time period as you do with many funds. You
have secondary and primary trading, that offers more avenues of liquidity,”
said Deborah Fuhr, co-founder of ETF consultancy ETFGI.
“They’re not exempt
from things happening in the market, they’re not a magical instrument, but I do
think they lack some of the deficiencies of other products in the market,” she
consultation by the International Organization of Securities Commissions
yielded few worries about liquidity risk in the ETF industry. Some respondents
suggested that secondary market trading in ETFs made them less susceptible to
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