Phil Mackintosh, managing director and head of trading strategy for Credit Suisse, recently visited IndexUniverse’s San Francisco headquarters and sat down with IU’s Global Head of Content Matt Hougan and Editor-in-Chief Drew Voros to talk about fixed-income ETFs, high-frequency trading and other topics.
IndexUniverse: There was quite a brouhaha with fixed-income ETFs—the premiums and discounts. As an opening question, are ETFs a good tool for access in the fixed-income markets?
Phil Mackintosh: Absolutely. They have incredibly good spreads and can often offer investors cheaper and retail-level access to bonds instead of buying individual bonds one by one. Plus, with ETFs trading intraday, investors also have the benefit of being able to trade in and out of them when they want.
In fact, sometimes I think the ETF wrapper can make it so easy for investors to get in and out of an asset class that they forget there are still underlying assets that all need to be traded for arbitrage to occur.
The brouhaha you mentioned is a great example of that. Just after the Fed started to discuss tapering, rates rallied significantly in a short period of time, and bond valuations fell in the underlying bond market. This led to significant bond outflows in both mutual funds and ETFs. And these outflows seemed to cause high-yield bond ETFs, in particular, to sell at a discount to their NAV.
But the fact that high-yield ETFs temporarily traded below NAV was misleading due to the fact that the high-yield bond market itself is mostly illiquid, and as a result, the bond indexes that track it sometimes have difficulty reflecting fair value in fast-moving markets. We also saw this in the credit crisis, but hindsight shows that those ETF discounts were a lot closer to the fair value of the bonds than the underlying bond indexes were.
IU: Do you think investors understand that?
Mackintosh: A lot of the problems ETFs get blamed for are actually due to characteristics of the underlying market. I think people forget that liquidity isn’t unlimited and arbitrage isn’t free.
IU: How would they come to understand that?
Mackintosh: That’s a really good question, because smaller investors usually don’t have the tools to calculate underlying liquidity that market makers do.
But offsetting that is the fact that underlying liquidity is really only a problem with large trades or periods of exceptional activity. For example, a hedge that is easy on a $10,000 trade might only get 90 percent complete on a $1 million trade, leaving market makers with additional risk.
Overall, what we find in our studies is that the U.S. ETF market is very competitive and efficient. In fact, we see that most ETF trades happen inside the spread of the underlying basket.
What market makers do in the bond space is incredible. We’re just starting to do analysis on bonds, and what we’re finding is that it’s really hard, because compared to stocks, there’s little data about the bond market. Information about underlying spreads or liquidity and even closing prices can be scarce. We’ve heard high-yield portfolio managers say that, often, only one in 20 of their securities actually trade on any given day, so trying to replicate that basket intraday is extremely difficult. Despite this, bond ETFs are trading 1-2 cents wide, with good liquidity for most investors.
Unfortunately, what gets picked up in the press are all of the relatively rare events where they don’t—days with extreme news, like the introduction of tapering; or a badly executed market order for 200 shares that causes a price to gap to a big premium to NAV for an instant. Just because the ETF is an efficient investing tool doesn’t mean it won’t be unaffected by underlying volatility and liquidity.
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