The latest Weekly Credit Outlook from credit rating agency Moody’s highlights some unusual institutional block-trading activity in SSgA’s high yield bond ETF, which, if reflective of a rising trend across all ETFs, could prove detrimental to retail investors and ultimately harmful to ETF sponsors.
According to Neal Epstein, CFA, vice president and senior credit officer at Moody’s: "Large block trades appear to have affected the relationship between JNK’s price and net asset value (NAV), causing investors trading losses."
The activity relates to an in-kind redemption on the SPDR Barclays Capital High Yield Bond ETF (JNK) earlier this month (10 May), in which an investor redeemed shares in exchange for bonds directly from the fund’s portfolio.
However, unlike routine in-kind creations and redemptions, which typically go under the radar, this trade was large – 19.7m shares worth $780m – and highlighted a number of risks relating to institutional investors’ increasing use of ETFs.
According to Moody’s, the rising institutional use of ETFs is “credit negative” for ETF sponsors such as BlackRock, Invesco and State Street, because retail investors and their advisers would be deterred from holding ETFs if they are exposed to elevated volatility and execution risk from large trades.
In addition, says Moody’s, such transactions elevate the potential for additional regulatory scrutiny and increased compliance costs for these products if their use as vehicles for implementing arbitrage strategies proves to amplify systemic risks.
The research’s author, Neal Epstein, CFA, vice president and senior credit officer at Moody’s, explained:
“Large block trades appear to have affected the relationship between JNK’s price and net asset value (NAV), causing investors trading losses. ETFs theoretically track the value of their underlying securities baskets. Subsequent to the large trade in JNK, an additional 14.4 million shares were extinguished, shrinking by 13.4% net assets of the fund overall through last Wednesday.
“In the face of this selling pressure, the fund’s price declined 2.7% and its price to NAV ratio sharply dropped to a discount of 127 basis points (bps) on 17 May; through 9 May, it had averaged a 40 bp premium for the year. This collapse in premium would have cost an investor a substantial portion of the year-to-date total return of the ETF, which was 5.9% through 30 April.
“In addition, there is evidence that JNK came under greater selling pressure than other funds from short sellers. From mid-April to mid-May, open short-interest in the ETF increased to 4.2% of shares outstanding from 3.6% before falling back to 3.4%. In comparison, a second large high-yield bond ETF, iShares iBoxx $ High Yield Corporate Bond (HYG), had very little variation in short interest during this time frame.
“While it is difficult to know for sure, the incentive for this trading activity in high yield bond ETFs could have resulted from arbitrage opportunities related to anomalous pricing in the credit default swap market created by JPMorgan Chase & Co.’s outsized selling of the Markit CDX index. Another possibility is that mispricing in credit default swaps caused traders to prefer the use of ETFs as hedging vehicles, which may explain variations in short interest.”
Whatever the background or motivation for these kinds of institutional block trades, their effect could prove destabilising. As the Moody’s analysis shows, the rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seems to be increasing investors’ risk.
While ETFs undoubtedly offer many significant and enduring advantages over traditional mutual funds (including transparency, liquidity, diversification, flexibility, performance and cost), any sign of increased volatility of pricing, as reflected in swings in the premium or discount of ETF prices relative to NAV, could represent a challenge to future growth for the ETF industry.
Perspective is needed, however, for in the closed-end funds and investment trusts industries premiums and discounts to NAV can vary significantly. Indeed, a report by activist investors Laxey Partners showed that average premiums/discounts for London-listed investment trusts ranged from +5.4% to -18.6% during 2011.
Furthermore, only last month Moody’s themselves released a report on ETFs, predicting growth for the industry. Joanne Job, Moody’s analyst, said “ETFs’ lower cost remains one of their most attractive attributes for investors, while many financial advisers have shifted to a fee-based from commission-based business model.” Job also noted the poor performance of actively managed funds, an increasing awareness of ETFs as asset allocation tools, and product innovation as reasons for the product’s growing popularity.