Institutions may be using exchange-traded funds to manage credit exposures at a lower cost — a move affecting the ETF market in new ways that could prove challenging for retail investors.
Products like BlackRock’s $13.4 billion iShares $ iBoxx High Yield Corporate Bond ETF (HYG) and the $12.06 billion SPDR Barclays High Yield Bond ETF (JNK) have seen record moves during the first half of this year, thanks to institutional and retail investors alike putting on tactical positions or seeking lower costs than they would get by investing with a high-yield fund.
For the week ended June 10, U.S. fixed-income offerings, including HYG and JNK, saw asset flows of $2.84 billion, according to data from ETF.com, a web site that tracks ETFs. One fund can see billions of dollars of activity in a single day; for example, HYG regularly leads the league tables for the fixed-income category.
“Being able to trade credit at a penny bid-ask spread, compared to having to source bonds and wait for markets to trade, is a huge advantage of credit ETFs,” says Justin Sibears, managing director and portfolio manager at Boston-based, $500 million ETF provider Newfound Research.
But all of this activity raises questions about liquidity risk and dislocations in the underlying credit markets, which don’t typically trade at the same rate as ETFs. Provisions in some of these products also allow for in-kind redemptions, so certain authorized participants could come away with the underlying securities instead of ETF shares. When that happens, the authorized participant can go back to the institutions that invested in the ETF and offer to give them the securities or sell them back into the open market.
Signs of volatility in some high-yield ETFs suggest that savvy traders are using in-kind distributions to run their bond businesses more cheaply than they could outside the exchanges. These ETFs give investors access to bonds on demand, letting them avoid buying and holding assets that might lose value over time, which is the practice in the traditional credit market. Allocating to such products also allows investors to take more dynamic views of the high-yield market because they can get in and out as conditions change — sometimes in the same day.
Last month it became obvious that institutional investors are using credit ETFs in this way. Both HYG and JNK saw billions of dollars in redemptions during the first four days of May, even though the broader markets were relatively calm and trending upward. Redemptions from HYG topped almost $3 billion before investors put $1 billion back in over the rest of the month.
At the time, Deutsche Bank ETF strategist Sebastian Mercado suggested in a research note that the moves were the result of institutions managing tactical allocations, rather than any kind of stress in the overall high-yield bond market. ETFs represent only a small slice of the $1 trillion U.S. high-yield business, but episodic moves in the billions of dollars are still notable. What happens if institutions opt to make tactical decisions during market turbulence? And could such moves potentially hurt retail investors who may have exposure to the same products?
These concerns are overblown, contends Richard Powers, Philadelphia area–based head of ETF product management at Vanguard Group. “The vast majority of trading in ETFs happens on the secondary market and only involves shares of the ETF, not the underlying securities,” says Powers, whose firm manages about $433 billion in ETFs. “Even when securities change hands, often the market makers keep them on the balance sheet, hedge the risk and pass cash or shares back to the investor.”
Powers points to recent instances of market stress, such as the one that occurred on August 24 of last year, when ETFs saw pricing dislocations during a major sell-off, and last December, when pressure in the high-yield market also impacted ETF prices. In both cases the volatility was the result of bigger market disruptions that affected all types of participants, not just ETFs, he says. And both times, ETFs were able to manage liquidity.
Greg Friedman, a Denver-based senior vice president at Fidelity Investments who heads product and strategy for SelectCo, the firm’s ETF division, agrees. “When events like last August happen, people want to blame ETFs, but ETFs only accounted for 33 percent of market volume on that day,” Friedman says. “Where people saw pricing problems had more to do with the order types than liquidity risk.”
Often investors place market orders to buy or sell at any price. Friedman, whose firm’s ETF assets total roughly $3.8 billion, says it may be better to consider a limit order, which has more pricing protection because investors can set bounds around the prices at which they’ll buy or sell. Fidelity and Vanguard are starting to publish more-educational pieces on order types for investors who may not know or who may be working with advisers and brokerages that only allow market orders.
Both Powers and Friedman argue that greater use of limit orders would have tamped down some of the volatility during the August sell-off. “What you saw there were some people who put in a market order and had it filled at 20 to 30 percent of NAV [net asset value], because they didn’t set limits,” Powers says. “When pricing is disrupted with a market order, you could be the one who hits the floor.”
David Fabian, managing partner and chief operations officer at FMD Capital Management, an $11 million, Irvine, California–based registered investment adviser firm that focuses almost entirely on ETFs, says that besides placing the right order type, investors need to look at how products are constructed. A liquidity mismatch with the underlying securities becomes more of a concern in smaller ETFs that have concentrations in very illiquid parts of the market, Fabian notes. When it comes to those smaller and more esoteric offerings, he says, it may be best for less sophisticated investors to leave them to institutions and hedge funds.
“If you’re unsure about what you’re getting into, one of the better ways to avoid making a mistake is by following the money,” Fabian says. “The biggest products are big for a reason. You’re also more insulated from liquidity concerns in a product that is trading millions of shares per day, because the secondary market volume will manage itself.”
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