Exchange-traded funds are a likely candidate for the next systemic financial crisis. While most bond fund managers cannot see why interest rates will rise, a major sell-off in bond ETFs would send all interest rates up.
The problem is that, while ETFs have delivered low costs, they cannot deliver on other aspects of their promises to investors. That creates scope for the kind of panic we used to think was limited to banks or money market funds.
The success of ETFs in recent years is astounding. Globally, assets managed have soared from $1.5trn in 2010 to $3.5trn today. The biggest increases have been in plain vanilla, market-cap-weighted bond and equity ETFs.
ETFs have created the promise of liquidity, which most investors take to mean they can sell as much as they want at any time on any day when the stockmarket is open.
This contradicts what the old textbooks on investment I read used to say, which boiled down to: “no derivative can be more liquid than its underlying”. By this, the ancient authors meant, for example, that the physical capacity for trade in a listed equity was the limiting factor for trade in options on that equity. In this case, options pricing puts the liquidity in a stock – or lack of it – into the price through formulas that make options on illiquid equities more expensive than those on liquid equities.
No such adjustment takes place in ETF pricing. On the contrary, the swap arrangements between funds and their trading partners mean the funds always price exactly in line with the market. Yet, especially in the case of corporate bond ETFs, the volume of trade in the ETF is often far greater than trade in the underlying bonds.
Many corporate bonds trade infrequently and with price gaps. These do not show up in ETF pricing, which, as far as corporate bonds are concerned, is “mark to model” – providers simply assume a price for a bond that has not traded for a while.
Mark to model is also the pricing basis for UK physical commercial property funds and, as we have again found out recently, it works fine – except for when it does not. Then, valuation uncertainty and lack of liquidity force either trading suspensions or price cuts.
My ancient authors also used to say that open-ended funds with daily pricing should not invest more than a small fraction of their assets in illiquid securities. Most authorised fund regimes enshrine this principle in their rules, for example, for unit trusts and OEICs, and, more generally, for UCITs. Corporate bond ETFs are a glaring exception to these principles, as are commercial property funds, yet regulators seem way behind the curve in dealing with the issue.
Some ETF providers claim they and their trading partners effectively are the market, and hence can provide greater liquidity than is available in the underlying securities. If this is true, it is an unprecedented act of fiscal alchemy that surpasses the conversion of lead into gold. More likely, it is not true and there is potential for a panic, meltdown and freeze in bond ETFs. That may not cause trouble in developed equity markets – typically deep and liquid – but is all too likely to cause chaos in bond markets.
Chris Gilchrist is director of Fiveways Financial Planning