Carl Icahn Is Saying Nothing New On ETFs

What do the Bank of England, the International Monetary Fund and the Financial Conduct Authority all have in common?

They all worry that if bonds sell off, there could be a rush to the exit, which could lead to the bond market freezing up and retail funds reneging on their liquidity promise.

These issues have been raised by prominent industry participants like Andrew Bailey at the BoE in May, in the IMF’s Financial Stability Report in April 2015, and in a FCA paper on the UK corporate bond market in January.

Therefore, billionaire activist investor Carl Icahn and Oaktree Capital Management’s Howard Marks’ recent criticisms of ETFs, particularly high yield ETFs, and warning that they may not be able to deliver in terms of liquidity, are nothing new. Commentators have voiced concerns, time and time again, that related retail products, not just ETFs, might not be as liquid as they would lead investors to expect. And although the warnings have some validity, these investors seemingly remain oblivious to recent developments in the bond market and to steps taken by ETF providers to address problems of potential illiquidity in this area.

Facts Behind The Talk

The liquidity warnings are underpinned by the fact that dealer inventories have dropped from over $520 billion in 2007 to around $170 billion today, despite significant net new bond issuance. There have also been air pockets of illiquidity like the flash crash on 6 May 2010 or on 15 October 2014, when the usually highly liquid U.S. Treasury market underwent a temporary freeze.

However, statistics from Dimensional Fund Advisors show that turnover in the corporate bond market has been relatively constant, when expressed as a percentage of the total bonds outstanding. Total turnover in the corporate bond market peaked in 2007 at close to 100 percent. In 2014 the corporate bond market turnover had dropped a little, but remained at a still very healthy rate of 80 percent. This suggests that, despite the lower levels of inventories, markets are still functioning and that concerns arising from lower inventories could be overstated.

One of the reasons why turnover has remained high is that capital is finding ways to move around and be liquid despite reduced bond trading activity at banks. For instance, fund managers are increasingly dealing with each other on a peer-to-peer basis, cutting out the banks and getting better execution. Trading on peer-to-peer platforms is estimated to have gone up by about 500 percent in the last five years. Liquidity has also been assisted by increased activity of pure bond brokers, who act as intermediaries, rather than as principals.

ETF Industry Is Two Steps Ahead

Furthermore, the ETF industry has been proactive in thinking about the risks they face in the bond market. The indexes being tracked by ETFs are mostly bespoke, liquid versions of broader benchmarks. Bond index providers exclude problematic areas in the fixed income universe like private placements, small issues, and unusual structures. They tend to stick to larger, more liquid bonds. Even then, the ETF issuers do not pretend to hold all the bonds in their indexes as this would be impossible to execute efficiently; they wisely say that their ETFs are “optimised” or “sampled”, holding a selection of bonds from the index to replicate its performance and give themselves some much needed wiggle room.

Some Risks Cannot Be Avoided

But no matter how proactive the ETF sector is, certain risks cannot be avoided. One is systematic risk. If everybody heads for the exit, there will certainly be periods of illiquidity. I enjoyed Oaktree’s Howard Marks’ broader comments when he pointed out that liquidity is “ephemeral: it can come and go”.  This is absolutely true of all markets, not just of high yield. Ask any Greek equity or China A-shares investor how ephemeral their ability to buy in and sell out has been this summer.

ETFs will inevitably suffer from liquidity that comes and goes, and we should perhaps be clearer about this with our end clients. The high yield ETFs, and other problematic areas, have not really had a severe test of liquidity yet – only time will tell how they will behave during that scenario.

What will happen during that scenario? Given new sources of liquidity and the steps taken by the ETF industry, my suspicion is that bid-offers spreads will widen considerably and the cost of liquidity will go up. Instead of trading at an apparent premium to intraday net asset value, these ETFs will fall and, if investors want to herd towards the exit, they may have to accept a beaten up price for their investment. But ultimately, as we have seen in Greece and China this year, trading will continue for those prepared to pay for it.