Are Carl Icahn, Howard Marks, And Heisenberg All Wrong About ETFs?

If there has ever been a moment where we’re tempted to apply the “famous last words” label, then surely this is it.

Regular readers will recall “What Happens When You Have To Play That Piano Drunk? Or, The Most Absurd Thing I Heard All Day.” In that post, we explained how ETF providers seem to be mistaking the problem (no trading in the underlying securities that underpin ETFs) for the solution (greater liquidity).

To be sure, we are not ETF providers and we are not APs. We do not participate in the creation/redemption process and although we understand it all too well, we couldn’t possibly claim to be as well versed in the technicalities as the ETF sponsors and APs themselves.

That said, we still contend there’s a certain extent to which ETF sponsors for HY bond funds are missing the forest (these things can’t possibly be more liquid than the underlying) for the trees (these things seem to work on a daily basis).

You’ll note that Carl Icahn and Howard Marks generally agree with us on that point.

Well in what looks like evidence that Heisenberg, Marks, and Icahn may be mistaken, Goldman is out with an interesting look at trends in HY ETF flow vol and NAV basis. That’s a particularly timely topic given the exodus we saw from HY following crude’s 10% collapse earlier this month.

Consider the following and draw your own conclusions about who’s right.

Via Goldman

Higher ETF flow vol = lower NAV basis vol.

In a continuation of a trend that started a few years ago, the volatility of HY ETF flows has further increased in recent months as shown in Exhibit 4. By contrast and as shown by Exhibit 5, the NAV basis, the difference between the ETF’s price and the net asset value of the underlying bond portfolio, has been moving within a tighter range vs. the period from 2010 to 2013.

The relatively low volatility of the NAV basis in the face of increasingly volatile flows suggests continued efficiency gains in the mechanics of ETFs. These efficiency gains essentially allow the ETF price gap vs. NAV to close relatively quickly even as the flow volatility moves higher. As we discussed on previous occasions, the rising volatility of ETF flows reflects a higher velocity in the ETF create/redeem mechanism, the process that allows ETF managers and authorized participants to minimize the ETF’s tracking error. This higher velocity, a byproduct of more aggressive liquidity provision and improving technology, shortens mispricing periods and thus pushes the volatility of the NAV basis lower. We expect ETFs will continue to capture increased activity, especially as they have demonstrated their ability to withstand volatility flows.

Floes

Coming full circle we ask: famous last words?

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