Markets so dominated by ETFs have not been truly tested by a post-QE world.
The following article was originally published in “What I Learned This Week” on December 6, 2018. To learn more about 13D’s investment research, please visit our website.
Speaking at the Lipper conference last month, co-chief executive of HanETF, Hector McNeil, warned the audience about rampant misunderstandings about ETF liquidity in the event of a market crisis: “This is similar to what the big hedge funds thought about products such as collateralized debt obligations before the financial crisis, and that was wrong.” For nearly two years, we have dissected the algorithmic and passive transformation of markets and the systemic vulnerabilities that could manifest as QE transitions to QT. And from the “VIX Tantrum” in February to “Red October” (see WILTWs February 15, 2018, and November 8, 2018), we have seen these vulnerabilities exacerbate market pain despite only lukewarm bad news. For all market participants, this should only heighten concern: What happens when truly bad news arrives?
In recent years, few debates have been more fervently contested than ETF liquidity. On one side, ETF evangelists claim two-tiered liquidity — exchange-level liquidity combined with asset-level liquidity — makes ETFs inherently more liquid than traditional market structures. ETF performance during market stresses of the past ten years has demonstrated this enhanced resilience, and therefore, concerns are overblown. On the other side, skeptics assert ETFs cannot be more liquid than the underlying assets, and in turn, the illusion of liquidity has only fomented institutional and retail investor complacency, which will backfire in the event of a crisis.
Regardless of how often it is discussed, the meteoric rise of ETFs since the Global Financial Crisis (GFC) remains staggering. In 2009, assets in ETFs totaled roughly $1 trillion. As of the end of October, that number had surpassed $4.8 trillion. In just the past three years, ETFs spiked from 20% of all U.S. equity trading volumes to 24%. Fixed-income ETFs are on the rise as well, attracting a record $141.6 billion in cash inflows in 2017.
Despite the evidence espoused by evangelists, the fact remains, markets so dominated by ETFs have not been truly tested by a post-QE world. Since the GFC, global central banks — especially the Fed — have served as market liquidity providers, filling the gap as regulation-restrained big banks have retreated from their traditional market-making roles (WILTW May 24, 2018). Much of that liquidity support has already been stripped away as QT has progressed.
Threats of a market crisis are rising, from geopolitical tensions and global growth concerns to the weakness of market leaders and over-indebted zombies. Therefore, the ETF liquidity question is more essential to evaluate than ever. And to our mind, the skeptic case is far more convincing than the evangelist case, meaning today more than ever, caution is an imperative.
One of the defining dynamics of the ETF-era — and the Digital Age as a whole — has been consolidation of power. On the exchange level, behemoths Vanguard, Blackrock, and State Street have seen their AUM skyrocket since the GFC (chart below). Vanguard alone owns at least a 5% stake in 491 stocks in the S&P 500, up from 116 in 2010, and roughly 7% of the entire index. As Vanguard founder Jack Bogle said last year, “Too much money is in too few hands.”
This exchange-level concentration presents a two-fold liquidity threat. First, there’s the “too-big-to-fail” problem: an idiosyncratic event at one of the large firms leading to massive redemptions that trigger a contagion across the asset management industry. Second, there’s the “true float” problem. As Bank of America Merrill Lynch warned last year: “The massive popularity of ETFs may be leading us on a road to a liquidity problem…The actual shares available, or true float for S&P 500 stocks, may be grossly overestimated.” Passive investors own roughly 22% of the U.S. market free float, according to Citigroup research. Fund manager Perennial encapsulated this issue in a note last year:
If a passive investment vehicle owns a large portion of a company’s free float, and will only buy or sell shares based on some type of signal, such as an increase or decrease in market capitalization, should we consider that free float?…Stocks that have a large portion of their float held in passive investments have seen their volatility increase, arguably because their true liquidity is lower.
However, it may be concentration on the “authorized participant” (AP) level, not the exchange level, where the ETF liquidity threat is most acute. APs are ETF market makers — financial institutions that deliver “a basket of securities to the ETF in the proportions specified by the index or formula that the ETF tracks,” as Investment News puts it. They can also do the reverse: “Turn an ETF share into the fund in exchange for the basket of securities it holds.”
They serve an essential role in keeping traded prices in line with NAV, profiting by taking advantage of arbitrage opportunities when an ETF stock price falls below the value of its underlying assets. However, if sustained market turmoil dries up liquidity in the underlying market, therefore sapping arbitrage opportunities, will ETF market makers — motivated only by profit — take to the sidelines, sending index prices into free-fall?
The GFC demonstrated the dire cost to markets when market makers stumble and retreat. This is why regulations were put in place to limit big bank market-making abilities. Yet, it appears ETFs have side-stepped those regulatory barriers. A handful of behemoths have solidified outsized power over ETF liquidity, as a recent Bloomberg profile of AP giant Susquehanna made clear. Susquehanna trades roughly 7% of U.S. ETF volume and more than $1.5 trillion in ETFs globally on an annual basis. In U.S.-listed options, the firm handles about a quarter of total trades. Meanwhile, Jane Street, founded by Susquehanna veterans, trades about $13 billion in global equities every day and handles 7% of ETF volume worldwide. We quote Annie Massa writing for Bloomberg:
Retail investors, attracted to ETFs because they’re easy to trade, may not realize how quickly that advantage could change, said Peter Kraus, former CEO of AllianceBernstein…“The liquidity of the ETF itself relies on market participants who actually trade them,” said Kraus…“I don’t think investors actually understand that risk.” The Financial Stability Oversight Council…has raised a similar concern, saying the ETF arbitrage mechanism is vulnerable to breakdowns in severe market stress.
Since 2015, Howard Marks has pointed to fixed income ETFs as the greatest concern. As he wrote in a memo in July of last year, “ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.” His warnings have not slowed the escalation of inflows into fixed-income ETFs, especially amongst institutional investors, who often execute “big-ticket” trades:
Earlier this month, Bloomberg profiled hedge fund manager and ex-Fir Tree director Adam Schwartz, who has staked half his firm’s assets along with his own cash betting credit ETFs will soon “perish in a bloodbath”. This is the scenario he imagines:
In a rout, where secondary liquidity in the ETF evaporates, authorized participants…will be compelled to redeem shares directly with the funds in exchange for bonds. But they’ll balk at receiving less-desirable securities…Anxious to maintain orderly trading, the funds will give away their most liquid securities, leaving a portfolio clogged with distressed and illiquid notes. At some point, APs will refuse to transact with the fund, sending the ETF shares into a death spiral.
Time will tell whether Schwartz’s bet pays off, but regardless, the scenario he outlines — which matches the warnings of Marks — merits concern. ETFs have revolutionized markets since the GFC, allowing unprecedented access and ease of trading. However, those strengths could become crippling weaknesses in the event of a bear market trauma — the liquidity illusion crumbling as easy buying becomes impossible selling. Combined with the ETF ecosystem’s over-dependence on a handful of “too-big-to-fail” firms, it could prove a recipe for a crisis. Like so many novel strategies deployed throughout market history, ETFs appear forever-liquid until they’re not.
The ETF liquidity question: Can the passive universe hold up in the event of a market crisis? was originally published in 13D Research on Medium, where people are continuing the conversation by highlighting and responding to this story.