Do exchange-traded funds (ETFs) represent a systemic risk? It depends on who you ask. Over the past few years, questions have been raised about whether or not ETFs can provide the liquidity they promise if investors en masse decide to make an exit. And more recently, investors have been shedding their exposure to bond ETFs after a year of record inflows, drawing further scrutiny over the ability of providers to keep up with the redemptions (see this post).
Over the last couple of weeks, however, the debate has become a bit more interesting, as a couple of notable (and very large) asset managers weigh in with opposing perspectives. On one side, Janus Capital’s Bill Gross) former manager of the world’s largest bond fund—the Pimco Total Return Bond Fund) and on the other BlackRock, the world’s largest asset manager and ETF provider.
Gross plants himself firmly on the ETFs are risky side by calling them part of a “shadow banking banking system” along with mutual funds and hedge funds. In his last Investment Outlook he points out they’re not required to maintain cash reserves as banks are, which means ETFs are vulnerable to liquidity shocks that could spread through the market. Here’s what he writes (the underlining is his):
The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk—presenting possible exit and liquidity problems in future months and years. Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
That’s his view.
Now for something completely different—a new white paper by BlackRock argues that ETFs actually foster market liquidity in the bond market particularly post-2008 when trading volumes are at historic lows.
As investors pour money into ETFs, new investors are also entering into the market, making it more accessible than ever. As the BlackRock paper points out, fixed income ETFs trade on average four to five times more frequently than the underlying market. But far from being a risk, bond ETFs are creating a more efficient market with an added layer of price discovery because they trade on the secondary market.
But it’s not all sunshine and roses—the BlackRock paper does point to much-needed fixes, including improvements in how liquidity risks are disclosed. BlackRock also suggests imposing of out of the money gates to pay back large institutional investors in kind rather than cash and using short-term borrowing to meet redemptions.
Those are the two sides—but what I find most interesting is the common ground in both. BlackRock and Gross together highlight emerging concerns over ETF liquidity and the need to deal with it either through disclosure, gates, or greater regulatory scrutiny.
Debate aside, that’s a conversation all institutional investors using ETFs should be having.
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