CitiWide Change Bank Is Back: Emerging Markets ETF Edition

I’m not sure how many times I’m going to have to go over this, but what I am sure of is that I’ll go over it as many times as someone else keeps pushing a patently absurd idea.

There’s a myth floating around out there that says ETFs can be more liquid than the underlying assets. That’s absurd. Ask Howard Marks. Or Carl Icahn. Two people who everyone will happily cite as authorities on anything whatsoever to do with capital markets as long as that “anything whatsoever” isn’t ETFs, in which case Icahn and Marks apparently have no idea what they’re talking about in the eyes of ETF proponents.

What’s hilarious about the contention that ETFs can be more liquid than the assets that underpin them is that those who make that argument are trying to refute a tautology which, by virtue of it being a tautology, is impossible.

One line of reasoning often employed by the crowd who believes ETFs aren’t dangerous goes something like this: the more volume/velocity there is in the ETF, the more well-behaved the NAV basis and the better the ETF is able to withstand volatile flows, and therefore we have more liquidity.

That’s silly. And to understand why, you need only refer to an 80s-era SNL sketch. Recall this from a week ago:

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).

Well Goldman (whose note was the motivation for the post that excerpt is from) is out pushing this absurd argument again, this time with regard to EM ETFs. Read below as the bank continues to argue the unarguable.

Via Goldman

EM bond ETF efficiency keeps up with explosive growth. As we discussed in last week’s Credit Line, credit ETFs have seen tremendous growth in AUM and notable efficiency gains. A similar trend has prevailed in the EM complex. Hard currency bond ETFs have seen their assets under management nearly double since the start of 2016 to all-time highs of $26.7 billion, according to data from EPFR (Exhibit 10). However, unlike in the case of HY ETFs, the volatility of EM ETF flows has been relatively stable since their genesis in 2010, as shown in Exhibit 11. The recent experience following the oil sell-off in March illustrates this as EM ETFs, unlike HY, continued to attract inflows. From a “mechanics” perspective, the volatility of the NAV basis on the EMB ETF, the largest EM bond ETF, has remained remarkably stable, notwithstanding a one-day spike in the session following Mr. Trump’s election when the NAV basis widened reflecting concerns with Mexico and the peso (Exhibit 12). The fast mean-reversion following the post-US election spike provides evidence of further efficiency in the EM bond ETF mechanism.