Somewhat surprisingly (given all the Trump headlines), Wednesday’s most popular post here at HR was “I Really – Really – Don’t Think This Is A Good Idea: ETF Edition.”
In it, I rehashed my all-too-familiar, common sense argument about ETFs. Here it is, in a nutshell:
What I do know is that if you step back from the unit creation/destruction process (which generally seems to be functioning well) and just abstract yourself a bit, this just seems like a bad idea.
After all, ETFs are kind of, sort of derivatives. Now there’s a vociferous debate about that and I’m really – really – inclined to say it’s just semantics. Because at the end of the day, you’re buying something that represents something else even if it is, in a way, also a manifestation of that thing it represents.
I then went on to highlight a bit of commentary from Deutsche Bank, who was – for all intents and purposes – out celebrating the fact that “ETF assets held by institutions and the number of products used by them have both grown more than 7 and 8 times in the last 10 years.”
If you assume that the proliferation of ETFs is a good thing and if you insist on obfuscating by calling them “ETFs” in the first place, then that sounds really, really encouraging.
However, if you translate it and strip it down to the basics, it sounds horrible. Here’s what that actually says:
Institutions use of derivatives that have never really been battle-tested has exploded by a factor 8 since the crisis.
How does that sound to you?
Throw in the fact that these vehicles failed miserably when given a chance to prove themselves on the morning of August 24, 2015, and the writing is on the wall. As an aside, I remember that morning vividly. I was head-down in geopolitical analysis when my mentor pinged me and a colleague in the pre-market with the following “subtle” suggestion:
Hey guys… market please.
In other words: “get your heads out of your asses because futs are tipping Dow -900 points.”
[Somewhere, someone is reading this and chuckling, no matter how much they hate me.]
Well anyway, Goldman is out on Thursday with a new note on my favorite punching bag: corporate bond ETFs, which I contend are the closest thing you’ll find to “financial weapons of mass destruction.”
As a reminder, the problem with HY ETFs is pretty simple: the underlying bonds are illiquid and as Howard Marks famously put it: “an ETF can’t be more liquid than the underlying.”
And while that’s common sense – indeed it’s tautological – no one seems to understand it and that’s because they’re missing the forest for the trees (with the trees being the “well-behaved” NAV basis). More on that in “What Happens When You Have To Play That Piano Drunk? Or, The Most Absurd Thing I Heard All Day”.
See the thing is, you cannot solve an absurd model with “volume.” I’ve variously illustrated this point by referring readers back to a classic 1988 SNL skit about a fictional bank called “CitiWide Change Bank.” The bank’s business model was simple: you bring them one denomination and they’ll give you any kind of change you want. The punchline comes from one of the bank’s executives who says this:
People ask us all the time: how do you make money doing this? The answer is simple: volume.
That’s the same ridiculous argument everyone is making about HY ETFs. Namely that the underlying problem (no liquidity for the bonds that the ETF represents) can be solved by more trading in the ETF (volume).
Note that in fact, it’s the exact opposite. That is, people who assert that are mistaking the problem (more trading in the ETF) for the solution. The more you trade the ETF rather than the underlying bonds, the more illiquid those underlying bonds invariably become.
So it’s with all of the above in mind that I present excerpts from Goldman’s new note without further comment, because quite frankly, my position on this (which mirrors that of Howard Marks) is simply unassailable.
The significant inflows into ETFs and mutual funds since 2010 have been one of the most salient post-crisis structural changes in credit markets (Exhibit 1). These inflows have significantly increased the ownership shares of ETFs and mutual funds. In IG, the market share of index-eligible bonds that is held by US and non-US domiciled credit funds more than doubled since 2010, reaching 17% as of the end of February, after years of steady growth, according to data collected from EPFR. For ETFs, the growth has been even more impressive with the ownership share growing from 1.5% in 2010 to 4.9% today (Exhibit 2).
In HY, the share of index-eligible bonds held by mutual funds has also increased over the past few quarters after declining from a peak of 29% in mid-2014 to a recent trough of 24.4% in mid-2016 (Exhibit 3). Relative to 2010, the ownership share of HY mutual funds has grown from 19.4% to 26.6% as of the end of February. As in IG, the growth of HY ETFs has been impressive, with their market share increasing to 4% of the index-eligible universe from 1.1% in 2010.
The growth patterns shown in Exhibits 1 to 3, particularly the increase in the ownership share of ETFs, have consistently raised concerns among fixed income investors and regulators. The fear is that the combined effect of the “liquidity mismatch” inherent to ETFs and a potential abrupt reversal of the inflows of the past several years could prove damaging to the secondary market. In February 2013, then Fed Governor Jeremy Stein echoed these concerns, pointing specifically to the growth of corporate bond ETFs: “If investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt.” Another frequently encountered narrative is that ETF inflows, the process through which new shares are created, exert decent technical pressure on secondary market prices and liquidity.
The past few years have seen HY ETF flows turn increasingly volatile (Exhibit 4). By contrast and taking the HYG ETF as an example, 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 (see Exhibit 5).
We view the relatively low volatility of the NAV basis in the face of increasingly volatile flows as evidence of 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.
We would note that, in contrast to HY, the volatility of IG ETF flows has actually declined over the past few years (Exhibit 6). The contrast likely reflects the more frequent use of HY ETFs as vehicles to dynamically rebalance credit portfolios, either as temporary substitutes to long positions in bonds (as was the case from mid-2014 to early 2016 when activity in the primary bond market slowed down materially) or as hedges to existing long positions. Like HY ETFs and as shown by Exhibit 7, the volatility of the NAV basis has come down for IG ETFs. The decline suggests that the efficiency gains in the plumbing of ETFs have also held true in the IG market.