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Chris Gilchrist: ETFs could be next for a meltdown

Chris Gilchrist 700

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

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. That’s half of it. The other half is the detrimental effect that these trackers have to investment, capitalism and the economy. A recent article (one of many in the quality press) in the Economist accuses ETFs and Trackers of Stealth Socialism. Creative destruction is being side-lined as investors are not able to hold companies to account in the same way as active investors. Arbitrage opportunities (a core capitalist device) are being lost. Where are the non-conformists and contrarians?

    Recent research has shown that the big three asset managers treated as a single entity are now the largest shareholder in 40% of listed US firms. (Accounting for 80% of the market) The asset managers have in effect seized the means of production. This cannot be good for capitalism.

    Passive managers cannot sell shares, if you track (say) the FTSE 100 you MUST hold those shares. Trackers are fine when markets are going up, but when they fall it’s like diving out of a plane without a parachute. Of course the great bulk of active managers don’t beat the index, but that is precisely what advisers are paid for – to find the ones that do – and they are not in that short supply. Do clients really need you to select trackers? How can you justify your charges – on sector allocation alone? Anyway as you will realise from the foregoing it isn’t only how much you make, but how little you lose when things don’t go well. That is precisely why you need the parachute of active management.

    As with so much else in this modern world investing has been dumbed down.

    • It’s a boomer thing. As Buffett says, ‘Diversification may protect wealth, but concentration builds wealth’. The boomers now want to protect wealth and are being persuaded to diversify to the point of diminishing returns. Expect smart advisers to move to a barbell strategy where they both take more equity and off-piste risk and put more capital in defensive AR or MA funds (and, of course, less in bonds).

  2. I have a deep abiding suspicion though that, when it comes to ‘finding the ones that do’, advisers are no better than those dart throwing chimps – ‘buy rating’ anyone?

    In that event, how one earth are they to justify THEIR charges?

  3. PS The Big Three PASSIVE Managers = BLack Rock, Vanguard & State Street

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