4th October 2013
Equity-based exchange traded funds have become a feature of the modern investing landscape and while some of the numbers may be eye-popping – $146.6bn currently resides in the SPDR S&P 500 ETF, for example – no-one frets too much about their impact in a liquid and readily tradeable market as Cherry Reynard reports. However, the bond market is a little different. Off-exchange and, at times, illiquid, bond markets do not play by the same rules as equity markets. Does the increasing prevalence of ETFs threaten to destabilise bond markets already trying to cope with the problems of the withdrawal of quantitative easing and rises in interest rates?
This is not an entirely new argument. ETFs have long been the bogey-man when an asset class sees an excessive sell-off over a short period of time. Markets are no more than a collection of buyers and sellers and ETFs, with their daily pricing and ready liquidity, allow investors to sell out quickly when they don’t like an asset class. This can exacerbate price moves in either direction. The ETF market has therefore been accused of creating some distortion in the bond market.
Certainly ETF selling can create pricing anomalies. Claire McGuckin, manager of the Kames High Yield Bond fund, believes that ETF selling may be responsible for the current disparity in valuations between the US and European high yield bond markets. She says the European markets are currently yielding around 5.3%, compared to 6% for the US markets. The US market has a great deal more ETFs based on it, which sent it lower than the European market. In other words, it was easier to exit, so people did. For her, this is creating an opportunity for active managers
A number of critics have suggested that the presence of ETFs in the corporate bond market is creating distortions. Notable among these is Fitch as Reuters reports. In a recent article, the wire service said: “Although U.S. corporate bond ETF assets total less than 2% of the US corporate bond market, their influence on trading activity is relatively more significant. Average daily trading volumes (on a weekly basis) for the five largest high-yield corporate bond ETFs more than tripled from about $470 million in early May to more than $1.5 billion in early June. This ramp-up in trading activity points to the value of ETFs for investors to rapidly enter and exit fixed income positions during a period of market turbulence. However, Fitch also notes that increased ETF trading volumes might also amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds.”
This would suggest that ETFs increase underlying volatility and will push markets lower at times of market stress. However, many dispute this view and suggest ETFs increase liquidity. Benzinga looked at the iShares iBoxx $ High Yield Corporate Bond ETF and the SPDR Barclays High Yield Bond ETF, the two largest U.S. junk bond ETFs, which hold a combined $23.4 billion in assets under management. It points out that while these funds were accused of not providing market participants with sufficient liquidity and making the tapering sell-off worse, there is evidence to suggest that high-yield bond funds behaved as expected during the recent period of elevated market stress: “A new study from BlackRock’s iShares unit, the world’s largest ETF issuer, indicates that these ETFs actually increased liquidity and price discovery for market participants during the recent sell-off. As liquidity in the underlying bond market contracted, exchange liquidity increased dramatically for ETFs; this allowed buyers and sellers of HY to meet and trade on exchange away from the over-the-counter market. The secondary market for ETFs actually served to enhance available fixed income market liquidity, and it also provided a source of price discovery for the underlying bond market, according to the study,” it said.
Deborah Fuhr, managing partner at ETFGI, argues that ETFs merely reflect market trends rather than cause them: “When investors feel that a new market is going to be less attractive, they sell. It is because there is something happening in the market. It is more that things are happening in the market and investors want to adjust their asset allocation. They use ETFs to do so. The ETF market remains small relative to the US markets and investors are simply reacting to news and experience.”
She gives the example of the slump in the gold price: “People were selling the ETFs because gold was going down. It wasn’t that gold was going down because ETF holders were selling…A lot of active people look to blame ETFs for everything.” She argues that it is because ETFs impose transparency on opaque markets that the difficulties arise. “ETFs can act as a price discovery mechanism when the underlying investment is not transparent.”
However, a recent piece in the Financial Times suggested that the ETF market is struggling because of the bond sell-off rather than vice versa. “A wave of selling caused many exchange traded funds to tumble below the value of their underlying assets as a bond market sell-off caused stress in the $2tn ETF industry,” it says.
ETFs allow investors to make short-term decisions. They will therefore reflect the mood of the market and allow investors to indulge their fear and greed with more speed and precision than might happen otherwise. As such, they can exacerbate movements in either direction, but the consensus is that they enable asset allocators to reposition quickly and therefore reflect the prevailing view of an asset class rather than create that view.
The Mindful View
Should investors be worried about liquidity and ETFs? Well, if you want to access many different types of assets, then the ETF market can let you do so. But some are more complicated than others. You should always understand what you are investing in. If you are in a junk bond ETF, then that clearly involves risks and you really ought to have some understanding of the asset and the product before you invest. With a debate over the impact of the ETF on the underlying market itself continuing that is something to bear in mind too. If you are concerned about not getting into something you don’t understand then it is probably wise to either use the services of a multi manager, DFM or mulit-asset manager who can bring that understanding or invest in something more vanilla including plainer ETFs. But it all really depends on the sort of investor you see yourself as.