19 November 2018

Could ETFs Fall Into A Liquidity Jam?

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The ETF industry is now worth more than $4 trillion, magnifying the risk if the funds run into difficulties.  

Bets against 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.  

Investors are 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.  

Still, other 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 stress well.

 “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 ETF shares.  

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.    

Different measures 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.  

But dealer 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 later on.  

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 system.  

“[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 added.      

A recent 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 liquidity risks.  

Click here for the original article from Wall Street Journal.  

 

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