Why Icahn Is Dead Wrong On ETFs

Legendary investor trips over how ETFs work.

Reviewed by: Dave Nadig
Edited by: Dave Nadig

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.

The Dreaded Rate Hike

Icahn’s second major point seems to be that BlackRock is promising fake liquidity in the bond market. His concern seems to be that when Federal Reserve Chair Janet Yellen and her colleagues agree to raise rates by 0.25 percent—say, in September—that junk bond investors will get slaughtered, head for the door and find no buyers.

Let’s tease that apart. We have another amazing piece of math to project exactly what’s going to happen to HYG when interest rates go up. It’s called duration. The shorthand for duration is that for each point of interest-rate rise, the price of a bond should go down by its duration (yes, I know that’s not precisely the math, but it’s the rule of thumb).

HYG currently has a duration of about 4. So doing the math on a 25 basis point hike (4 x 0.25) implies that the actual price of HYG should come down a whole 1 percent on that fateful day. Of course, the fact that HYG gets 1 percent cheaper also means that the yield will kick up slightly, which attracts new money to the fund.

But again, let’s pretend that Icahn is right, and that the 25 bps hike sends people running for the exits. What about liquidity?

Transcendent Liquidity?

In Icahn’s disaster, everyone wants out of junk bonds and the ETFs make it all worse. Let’s put a few things in perspective.

The junk bond market, depending on who you ask, is about $1.5 trillion. If you add up all of the assets in all of the junk bond ETFs, you get $41 billion, or about 3 percent. That’s an awfully short tail to be wagging the junk-bond-market dog.

Where Icahn is right, however, is that liquidity in junk is terrible. The bond markets of old are long gone, and many junk bonds now basically trade by appointment, and even then only if you know who to call. If you’re unfortunate enough to have bought an individual junk bond, and Icahn’s disaster happens, it’ll indeed be very, very hard to unload your bonds.

In the ETFs, this will show up as a discount; that is, the ETF price will go below its “fair” value. The quotes are around “fair” because, in a true bond panic, nobody will actually know what the “fair” price is—except for ETF investors, who will know exactly what the market is willing to pay for their shares. While the prices would be ugly, there would at least be prices, and there would at least be trades.

Why am I so confident? Remember, the price of an ETF is based on the arbitrage opportunity between the ETF price and the price of the underlying securities. When things get squirrelly, authorized participants will allow the price of the ETF to drift to a point where they think they can still make money. They will then step in to be that buyer of last resort only when they are sure that the basket of bonds they’ll receive doing a redemption can be unloaded for a profit.

Profit motive is a powerful force, and in any crisis, there will always be some price at which an entrepreneurial soul will feel they can still make money buying cheap now and selling high later. Remember, even Lehman debt eventually got sold to someone for pennies on the dollar.

Which would you rather be in—an individual junk bond you can’t unload at any price, or an ETF that’s trading at a discount, but is at least trading? I’d rather be in the ETF.

No ‘Kayfabe’ Here

The reality, which Fink tried to get across, is that there is no secret here. There is no collective delusion covering up some hidden secret that the ETF market is as fixed, as is the “Royal Rumble” in pro wrestling. There really can’t be, because ETFs are actually incredibly simple, and incredibly transparent. They simply are what they seem to be.

If Icahn doesn’t want to be in junk bonds right now because he thinks you take too much risk for the return you’re getting, that’s his prerogative. Heck, I don’t have any junk bonds in my accounts either right now. Those are personal investment decisions.

But to call BlackRock “dangerous” for offering “that HY thing” to investors who want the exposure? That’s just being a heel.

At the time of this writing the author held no positions in the securities mentioned. Dave Nadig is the Director of Exchange Traded Funds at FactSet Research Systems. You can reach him at [email protected], or on twitter @DaveNadig.

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.