The alchemy of ETF liquidity is an illusory promise

Financial alchemy is never defeated, it seems.

Not all that long ago, bankers and asset managers promised to turn subprime mortgages into gold-plated, triple-A rated bonds.

Today, the apparently miraculous transformation is of deeply illiquid credit instruments, such as junk bonds and leveraged loans, into hyper-liquid exchange traded funds.

Those who fear these ETFs hold the seeds of the next crisis have been circulating the latest quarterly letter from investment guru Howard Marks excitedly. His disquisition on liquidity (www.oaktreecapital.com/MemoTree/Liquidity.pdf) is a must read for anyone considering purchasing an ETF comprised of corporate bonds, emerging market debt or leveraged loans.

That the alchemists have created another accident in waiting has been a fear of bond market mavens and regulators for several years. Fixed income ETFs now hold $330bn in assets in the US alone, according to ETF.com. Their rise has been one of the great market changes since the crisis, and there are many reasons to suspect they could play at least an exacerbating role in the next one.

Even though the underlying bond and loan markets remain difficult to trade, ETFs offering baskets of such instruments trade moment to moment on the stock market. This is to the delight of retail investors and speculators who have none of the skills, connections or patience to assemble and assess an actual portfolio of the things. That business is done behind the scenes by Wall Street companies acting as arbitrageurs. Their ability to trade and keep ETF prices in line with the underlying instruments is yet to be tested in a period of significant market stress.

Mr Marks is adamant: "No investment vehicle should promise greater liquidity than is afforded by its underlying assets. If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually illusory, fleeting and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times."

By contrast, the alchemists - the creators of these ETFs, led by Invesco, State Street and BlackRock - argue that by bringing new money into junk bonds and levered loans, they have swelled the liquidity of these markets, while moment-to-moment trading has improved price transparency.

The debate was stoked, not settled, by 2013's "taper tantrum", when bond markets swooned in response to a Federal Reserve signal that it would wind down its quantitative easing programme. Discrepancies briefly opened up between the price at which you could sell your emerging market bond ETF and the value of the funds' underlying portfolios, raising the question of what will happen if a Fed rate rise causes something worse than a tantrum.

Something else to worry about: the leveraged loan market is antiquated and plagued by paperwork backlogs, so that settling trades can take three weeks. Sellers of leveraged loan ETFs, though, are promised their money back within three days. This big mismatch is no problem if fund redemptions come in a trickle, but what will happen if there is a flood?

The ETF structure may well prove robust, but that does not mean ETF investors will escape nasty surprises. This is the central point of Mr Marks's masterclass. Liquidity is not really about whether you can sell your holding; it is about the price at which you can sell - and that ETF sale price could become a fire-sale price really very suddenly. Is this a risk that buyers have factored in?

"Usually, just as a holder's desire to sell an asset increases (because he has become afraid to hold it)," Mr Marks wrote, "his ability to sell it decreases (because everyone else has also become afraid to hold it) ... Just when you need liquidity most, it tends not to be there."

For investors who have bought assets for the long term, expecting to ride out periods of market volatility, moments of illiquidity are largely irrelevant. In fact, for those with conviction, those moments present a great opportunity to increase a position at a bargain price, buying from panicking sellers.

The question is, who are the holders of bond and leveraged loan ETFs? Are they long-term investors? Contrarians with conviction? Or are they something more human, more mundane: investors who have chased investment returns and will want to move en masse, and quickly, when the going gets less good?

If so, they may find the promises of liquidity to be as illusory as the promises of alchemy that have come before.

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