Ok, dammit.
One of the things that’s been bugging the hell out of me for at least two years is the prospect of active mutual funds using HY ETFs as a liquidity sleeve or, more to the point, as what amounts to a cash substitute.
Basically, they’re managing flows with ETFs in order to avoid the cash market for the underlying bonds. That may not sound inherently nefarious (and maybe it’s not), but it is damn sure some semblance of incestuous. Because it’s obvious what they’re doing, right?
I mean if you’re a high yield mutual fund and you’re holding HY ETFs then what you’re trying to do is have your cake and eat it too. You can stay fully invested via the ETFs but claim to have a cash buffer because after all, the ETFs are liquid. Obviously, that’s bullshit. Those ETFs are not cash. You can mitigate flows with them (i.e. dodge the cash market for the underlying bonds by selling portfolio products instead), but in the final analysis, that’s a shell game.
Back in 2015, Reuters reported that some ETF issuers were increasing credit lines in order to ensure they could manage outflows without inadvertently triggering a fire sale in the HY market. Part of the problem here is that in the post-crisis regulatory regime, banks are less willing to lend their balance sheet in a pinch, and so with the middleman thus hamstrung by regulatory reform, some of these fixed income products need to figure out what they’re going to do in the event a wave of outflows comes calling.
I’m not going to dive back into this debate too deeply here, but the bottom line is (and has always been) precisely what Howard Marks said in 2015. Namely that no matter what anyone tells you, the ETF cannot be more liquid than the underlying and in a pinch the ETF will be precisely as liquid as the underlying assets and no more. Period. It’s great (I guess), that we’ve developed a mechanism that effectively transforms relatively illiquid bonds into ETFs with daily liquidity and yes, that mechanism does seem to be getting more efficient over time (i.e. the NAV basis has been well-behaved), but in a fire sale scenario, it won’t work. Especially not when dealers are reluctant.
I’m not saying this can’t work indefinitely – clearly it can. What I’m saying is that it is inherently unstable by virtue of flying in the face of common sense. Generally speaking, things that fly in the face of common sense tend to blow up eventually and this is no exception.
Ok, well during last month’s HY fund exodus, Citi warned that there was probably some double counting going on because there’s no way to know how much of what everyone was seeing in ETF flows was actually mutual fund managers using those ETFs to mitigate their own fund flows. One thing seemed certain: folks were going where the liquidity was, tapping the ETFs and also CDX in an effort to (again) dodge the cash market.
Well Barclays is out with an exhaustive look into this dynamic (you’ll recall that they wrote the seminal piece on how ETFs and portfolio products are being used to mitigate flows back in 2015 when the debate about HY ETFs was really heating up).
First, the bank notes that although outflows from HY mutual funds “exceeded 4.4% of AUM over a short period of four weeks ending last Wednesday rank[ing] among the four largest outflows for similar periods and [clocking in at] the largest since August 2014,” those flows were actually “well below those experienced in other products — notably, high yield ETFs [where] HYG and JNK, the high yield ETFs with the most assets under management, saw the largest-ever percentage decline in their combined shares outstanding, with a near 18% drop over the one-month period ending last Wednesday, dwarfing the 4.4% decline in mutual fund AUM over the same period.”
You can see a similar dynamic in CDX, where investors flipped net short for just the third time in half a decade:
Ok, now comes the question: how much of this is double counting. As Barclays puts it, “it is possible that much of the selling in portfolio products was driven by mutual funds themselves, to fund the outflows that they were experiencing.”
In order to estimate this, the bank first tries to figure out how much of the outflows from ETFs were retail investors selling, a figure they approximate by (basically) just assuming that the selling in the ETFs was roughly equivalent to the selling in high yield mutual funds. To wit:
Assuming a 50/50 retail/institutional split of ETF ownership, this implies $1.1bn of ETF outflows from retail: [$52bn in ETF AUM]*[50% retail ownership of ETFs]*[4.4% in retail outflows]. The residual $4.4bn of outflows would then be attributed to institutional holders, representing 79% of the total share destruction
That’s probably understated and there’s a laborious exercise to account for that, but ultimately, if you just kind of skip to the important point, Barclays shows you the following chart which attempts to estimate how much of the ETF share destruction was down to mutual funds using those vehicles to mitigate flows. They assume institutional selling at $5.5 billion and haircut that by 25% (so they assume that three quarters of that selling was mutual funds) and then they suggest that of the $3.5 billion in protection sold on CDX.HY, about half was attributable to mutual funds.
Ok, so clearly, the question is what happens if outflows from mutual funds continue. Because now they’ve sold those ETFs they were effectively using as a cash buffer and they’ve spent $1.8 billion buying protection.
In the short-term, Barclays suggests they’ll likely rebuild their buffer by simply buying the damn ETFs again and selling protection.
“Our assumption is that managers will, at the very least, need to repurchase the ETFs sold and increase long CDX exposure against the protection that they bought,” the bank writes, adding that “in the foreseeable future, they will have to fund this buffer — typically defined as a percentage of AUM — either through inflows or by selling bonds.”
So we’re right back in the same absurd dynamic. They sold the ETFs to avoid selling the bonds and now they need to rebuild their ETF position (because they’re using that as a cash substitute) by selling those same damn bonds. It’s absurd. It’s a shell game. Here’s the conclusion from Barclays:
Given that combined JNK and HYG shares outstanding have increased by 4%, after reaching a low in the middle of February, while mutual funds have continued to experience outflows, we posit that the recent share creation has been facilitated by selling bonds. This, combined with our estimate of ETF selling by mutual funds from the analysis above, implies that managers will still have to buy back roughly $2-3bn in ETF assets to fully replenish their buffers. Recent data suggest that managers have been using CDX even more aggressively to address their liquidity needs. After buying $3.5bn in protection through mid-February, managers have sold roughly $1.6bn in protection in subsequent weeks, and we estimate that an additional $1.0bn will need to be sold before institutions meet their liquidity targets. Of course, we cannot definitively attribute the increased balances in portfolio products to the same funds that experienced outflows. But we would expect those funds to rebalance along those lines over time as they re-establish appropriate liquidity buffers.
Again, I’m not saying that this give-and-take/swapping of portfolio products/relying on flows being to a certain extent diversifiable can’t work indefinitely. Clearly it can. But if you read everything above this is a pretty delicate scenario where everyone seems to be doing everything in their power to manage their immediate liquidity needs while putting off transacting in the underlying bonds at least until the storm has passed.
The question is, was, and will always be this: what happens to the underlying market for the cash bonds if the storm doesn’t pass next time?
[Side note: I should mention that Barclays isn’t positing anything nefarious here and they do not describe this as a shell game. In fact, they note that since there’s double counting going on, what you saw in terms of outflows last month probably wasn’t emblematic of panicked de-risking. In short: their point is simply to outline the dynamics. It is my opinion that the dynamics will spell trouble at some point, sooner or later]
