Concerns that thinly traded securities will create liquidity problems for ETFs and, vice versa, that ETFs will exacerbate liquidity problems for thinly traded securities underline a general misunderstanding of the benefit ETFs provide through their unique structure. This was articulated in a recent article by Ben Johnson, director of global ETF research at Morningstar.
ETFs provide increased liquidity and transparency for high yield bonds.
Essentially, critics are apprehensive that ETFs tracking illiquid securities, most notably high-yield bonds and senior loans, will experience a liquidity crisis when interest rates rise.
Although issues may arise in heavily depressed markets where investors are scrambling for an exit, this scenario is not confined to ETFs. Far from it, ETFs generally support increased trading in ordinary markets thereby promoting price discovery and trading efficiency.
One factor often cited as a concern is that mutual funds and ETFs tracking fixed income securities have tripled over the past decade while providers of liquidity in traditional bond markets have dwindled in number. These opposing trends may result in a liquidity crisis when these markets are subjected to strong selling pressures. But this is not a fault of ETFs, and more a characteristic of debt markets.
Indeed, debt instruments have traditionally faced liquidity issues relative to trading in stock markets. These arise from large minimum investment requirements and a lack of secondary exchanges from which to conduct trading (most transactions take place in the over-the-counter market). The unique features of each bond compared to equity homogeneity also limits demand; a single issuer may have over 1,000 different bonds, varying in coupon, size, maturity or level of seniority.
One of the key benefits of ETFs is their ability to mitigate these problems by organising relatively illiquid securities into a standardized basket that trades like a stock on an intra-day basis. This reduces minimum investment requirements and provides an efficient secondary market to trade in, broadening and deepening the investor pool through increased buyers and sellers. The real-time trading of these funds provides a level of transparency that was previously unobtainable for these underlying instruments.
As such, since the launch of the first high-yield bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), in April 2007, there has been rapid growth in both the number of ETFs tracking high-yield bond indices and the amount of assets dedicated to them. Investors have recognised ETFs as a cost-efficient method of obtaining exposure to these assets without the traditional downsides. There has also been a move to construct funds around even less liquid assets such as senior loans and other subordinated debt.
It is true that in troubled markets, the cost of liquidity will indeed rise. This will be evidenced by increasing bid-ask spreads and a negative impact on price as larger positions are sold. The price decline and liquidity risks, however, will affect all holders of the underlying securities regardless of whether the investor owns the security directly or through an investment vehicle such as a mutual fund or an ETF.
The willingness of authorised participants plays an important role here. Their ability to step into the market to facilitate creations and redemptions further increases liquidity and narrows the range at which trading values would deviate from net asset value through the process of arbitrage. In the event of a massive sell-off, where supply of the ETFs far exceeds demand, authorised participants would buy the oversupply and bring equilibrium back to the market. This mechanism has been stress-tested several times in the past with high success.
According to Ben Johnson: “They functioned remarkably well during the worst days of the financial crisis. In fact, at certain points they were one of the only remotely reliable sources of liquidity and price information. This pattern has subsequently repeated, as evidenced by the spikes in fixed-income ETF trading that have coincided with intermittent bouts of volatility in the bond market – most notably, the 2013 ‘Taper Tantrum.’”
It should also be noted that investors holding high-yield bond ETFs during a panicked downturn will only realise their losses if they panic along with the market and sell their investment. In fact, the bear market may provide a profitable buying opportunity if the investor is willing to hold the position for the medium to long run. This highlights the point that these underlying instruments are generally suited for long-term investors, regardless of whether they are repackaged through ETFs or directly held.