Why Icahn Is Dead Wrong On ETFs

July 16, 2015

Wednesday's verbal battle between activist investor Carl Icahn and BlackRock Chairman Larry Fink was the “Wrestlemania Headliner” of investing.

As I watched these two gentlemen in their bespoke suits sparring with words, I couldn’t help thinking of professional wrestling. CNBC, which produced a fantastic lineup for its “Delivering Alpha” conference, promoted the conversation between the world’s most famous activist investor and the head of the world’s largest investment manager the same way announcers hype Wrestlemania: “Two men enter, one man leaves!”

But more than anything, Icahn set himself up as the man speaking truth to power. In pro wrestling, there’s a term for the illusion that the matches and the hype are real: kayfabe. Icahn set himself as the man breaking kayfabe. While both gentlemen were polite, Icahn eventually devolved to calling the entire ETF structure a scam, and BlackRock a “dangerous” company for promoting them.

As someone who’s spent his entire career since 1993 focused on index and ETF investing, my knee-jerk reaction is to write off such name-calling as ill-informed. However, CNBC has a big audience, and Icahn has a large (and justified!) following. So let’s examine his specific concerns one-by-one.

‘That HY Thing’ Is A Scam/Bubble/Dangerous

While it was good for a laugh that Icahn couldn’t remember the ticker for the largest high-yield ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64), his fundamental concern about this one fund is twofold. The first is that high-yield bonds are in a dangerous bubble; the second is that HYG (and by inference, all ETFs) promise “fake” liquidity.

On both of these points, Icahn is drawing some odd conclusions. Let’s start with:

The Junk Bubble

The current yield to maturity on HYG is just around 5.6 percent. The slightly junkier SPDR Barclays High Yield Bond ETF (JNK | B-68) is about a percent higher. To put that into perspective, if you went into U.S. Treasurys of similar maturities, say, the iShares 3-7 Year Treasury Bond ETF (IEI | A-71), you’d only get about 1.5 percent in yield. That spread difference of around 4-5 percent (depending on how junky you go) is a little wide, by historical standards.

So what does “a little wide” mean? It means that from a historical perspective, Icahn is wrong.

We have a really good way of measuring this difference between Treasurys and junk. It’s called the “option adjusted spread” (OAS), and it tells us, embedding all of the potential options implied in various bond terms and conditions, just how expensive or cheap a bond portfolio is compared with a risk-free rate. Here’s how it looks right now for junk:

You can see that, by historical standards, we’re a bit over the norm of 4.5 percent. Remember, this is bond territory, so a high OAS actually means the price of junk bonds is low compared to Treasurys. There can be two reasons for this: Either the market is more worried about defaults than normal (and thus demands the high yield), or they are simply under-bought and out of favor.

I don’t know many economists actually worried about a rash of defaults right now, so that implies they’re under-bought—the opposite of a bubble.

But let’s cede Icahn this point. Let’s say we all agree that black is white, and imagine spreads were at historical lows. Let’s move on to his disaster scenarios.

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