Does ETF ‘Bottleneck Risk’ exist?

As global regulators look at liquidity pressure points, The TRADE asks what role do Exchange Traded Funds have to play in the next global crisis?

By Editorial April 01, 2016 9:05 AM GMT

In recent months exchange-traded funds (ETFs) have been in the firing line of regulators amid ongoing liquidity concerns around the world.

ETF issuers have responded, saying that their funds have important advantages over traditional savings vehicles.

Having imposed stringent new regulations on banks and hedge funds after the 2008 financial crisis, regulators have turned their attention to a sector of the savings industry traditionally seen as unexciting.

“The big question for us now is about liquidity cycles that come from fund managers that don’t have leverage…[from] mutual funds that invest in relatively illiquid securities,” said Mark Carney, Governor of the Bank of England and Chair of the G20 Financial Stability Board, in 2015.

Regulated mutual funds have seen a near five-fold rise in their assets under management since the turn of the millennium.

But it is the $3 trillion ETF business that has attracted particular scrutiny from regulators from the wider $36 trillion funds sector.

Why so serious?

An ETF is a type of mutual fund that can be traded intraday by market participants, both on stock exchanges and in the bilateral, over-the-counter (OTC) market.

By contrast, a conventional mutual fund is traded once a day, usually at the market close and through transactions struck directly with the fund issuer.

Last summer, US hedge fund manager Carl Icahn launched a public attack on ETFs, labelling BlackRock (the largest global issuer of ETFs) as a “dangerous company” and alleging that BlackRock “sells liquidity” via its iShares range.

Focusing on iShares ETFs that allow investors to place intraday trades in baskets of high-yield bonds, Icahn argued that “there is no liquidity…and that’s what’s going to blow this up.”

Fund run risk

Regulators’ recent concerns focus on the capacity for any mutual fund, including ETFs, to trigger wider instability by an inability to meet investor redemptions on time and on demand.

In April 2015, the International Monetary Fund (IMF) published a paper in which it argued that “run risk” could affect not only a single fund, but a whole fund family, triggering wider macro financial consequences such as fire sales and system-wide volatility.

A test case came late last year, when a $1 billion US mutual fund investing in high yield bonds, the Third Avenue Focused Credit Fund, imposed a freeze on outflows after being left with a rump of bonds it was unable to find buyers for.

The 9 December closure of the Third Avenue fund triggered widespread investor nervousness and a bout of redemptions in the largest high yield bond ETFs.

In the five days to December 14, iShares’ $ High Yield Corporate Bond ETF (HYG) saw 7% of its assets redeemed, while its competitor, State Street’s SPDR Barclays High Yield Bond ETF (JNK), suffered a loss of 15% of its assets.

However, around 80% of the mid-December selling pressure in iShares’ High Yield Corporate Bond and State Street’s SPDR Barclays High Yield Bond ETF did not cause redemptions of fund units.

When trades in HYG posted hit an all-time high of $4.3 billion on December 11, the ETF saw redemptions of $555 million: the remaining sales were met by offsetting demand from secondary market buyers.

“The shares of high-yield bond ETFs were highly liquid during the December sell-off,” John Hollyer, principal and head of risk management at asset manager Vanguard, told The TRADE.