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?

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.

Inflows and outflows

ETF issuers are keen to point out that the secondary market trade-ability of their funds is a key design feature.

“A premise when setting up ETFs is to try and minimise primary market activity,” says Manooj Mistry, head of exchange-traded products in Europe for Deutsche Asset and Wealth Management.

“The secondary market is an absorption mechanism where any redemption pressure can be offset. The ETF ecosystem can offset some of the constraints faced by a traditional mutual fund.”

Compared to mutual funds, “ETFs have three levels of liquidity, the on-exchange market, the OTC market and the ETF primary market,” Simon McGhee, head of ETF advisory in Europe at BlueFin Trading, told The TRADE.

In the traditional mutual fund model, issuers also face the challenge of avoiding “dilution” – in other words, ensuring that investors entering and exiting a fund do so at a price that doesn’t disadvantage existing investors.

If trades in a mutual fund take place at a single daily net asset value (NAV), which is common practice in the US market, dilution is hard to avoid.

In Europe, most mutual fund issuers choose to “swing” their fund’s daily dealing price up or down to reflect the trading costs incurred as a result of net inflows or outflows. The Securities and Exchange Commission (SEC), which regulates US mutual funds, is currently mooting the introduction of swing pricing.

For ETFs, however, dilution isn’t a worry, since the ETF’s price trades freely within a band that reflects the costs of creating and redeeming fund shares.

“In an ETF, the costs of liquidity are externalised: they are borne by the people demanding liquidity,” says Vanguard’s Hollyer.

ETF creations and redemptions rely on interactions between specialised intermediaries – called authorised participants (APs) – and the fund issuer.

At any time during the day, the AP can supply a creation “basket” – a collection of the shares or bonds held by the fund – to the ETF issuer and receive ETF shares in return.

A basket case

For redemptions of ETF shares, this operation takes place in reverse. For ETFs investing in liquid markets, the make-up of creation and redemption baskets typically reflects the whole ETF portfolio.

For ETFs holding less liquid assets, however, creation and redemption baskets may be only a small subset of fund constituents. There may also be an element of negotiation between the AP and the ETF’s portfolio manager.

“APs may suggest a subset of a fund’s securities to the issuer as the creation basket, or may receive a list from the issuer and agree to provide a certain number of the securities,” explains Grégoire Blanc, head of capital markets at ETF issuer Lyxor.

In theory, the practice of using a small-size basket could increase the risk of the ETF manager meeting redemptions by selling the most liquid assets of the fund first, disadvantaging remaining investors. This practice appears to have been what got the managers of Third Avenue’s Focused Credit Fund into trouble.

Paul Young, capital markets specialist at State Street Global Advisors, refutes the suggestion.

“It’s not in the ETF portfolio manager’s interests to use a creation or redemption basket that is less representative of the fund, since this would create more tracking error against the index,” says Young.

“And if you constantly give APs a less representative or less liquid basket, they are not going to support your product,” he adds.

The mutual fund model

The managers of daily dealing mutual funds have additional weapon to meet potential redemptions – maintaining a buffer of liquid securities and cash. ETFs, which track indices, have little choice about what they hold, while any substantial cash holdings would create an undesirable divergence in performance between an ETF and its benchmark.

“If we anticipate outflows, we can hold more liquid assets like government and supranational bonds,” says Bryn Jones, director and fixed income mutual fund manager at Rathbone Brothers.

Jones added that the managers of funds which have experienced a period of relative underperformance are more likely to expect investors to leave.

Knowing your client is also easier for the managers of traditional mutual funds than for ETF issuers, since mutual fund houses, via their transfer agents, have a full register of individual holders. Since secondary market transactions in ETFs do not involve the fund issuer, ETF houses, by contrast, have limited visibility into the ultimate ownership of their funds.

According to Philip Warland, head of public policy at Fidelity International, market intelligence can help address mutual fund managers address potential liquidity challenges.

“Insurance funds and pension funds are relatively slow to change their mutual fund holdings,” says Warland.

“Retail investors are also quite sticky, even though collectively they tend to buy and sell at the wrong time. But one category of investor we watch more closely is global wealth managers and so-called asset allocators. They can change their market views quickly and move billions of pounds at one fell swoop. Talking to them regularly helps us know their intentions.”

Pros and cons

The pros and cons of traditional mutual funds and ETFs appear nuanced. In aggregate, fund flow data suggest that investors are shifting towards the ETF model, however.

According to Leveraged Commentary and Data, a unit of S&P Capital IQ, traditional US high-yield bond mutual funds lost US$7.1 billion in assets last year, while high-yield ETFs had a net inflow of just under $1 billion. Steady inflows during the last decade mean that ETFs, in aggregate, have increased their share of the global mutual fund market from 2% in 2002 to around 9% currently.

Some ETF investors suggest that liquidity fears are overdone.

“In August 2015, when the markets were shaky, we sold US$100 million of a global emerging market debt ETF, traditionally a less liquid asset class,” recounts a London-based wealth manager, who requested anonymity.

“We were nervous as hell ahead of the trade but we were able to liquidate the holding in a second. Our experience was extremely positive.”

Ultimately, any debate about different fund structures’ liquidity risks only goes so far. Raphael Dieterlen, head of ETFs and index investing at Lyxor, strikes a note of realism.

“Whether you have a conventional mutual fund or an ETF that invests in high-yield bonds, in a crisis you may face a challenge selling the fund’s assets,” Dieterlen told The TRADE.

“ETFs are just tracker funds that provide exposure to an underlying asset class. You cannot assess the ETF without assessing the underlying.”