Checking out of the ETF hotel could be costly; Worry is that market-making dance may come to abrupt halt

Last updated: May 23, 2014 3:54 pm

Checking out of the ETF hotel could be costly

By Tracy Alloway in New YorkAuthor alerts

Worry is that market-making dance may come to abrupt halt

Hotel California by the Eagles is one of the best known soft rock songs from the seventies. But its lyrics – about a seemingly welcoming guesthouse revealed as a ghostly limbo – offer a partial analogy for an important part of modern financial markets: exchange traded funds.

Exchange traded funds have long appeared attractive to investors. They promise quick and easy access to a wide variety of assets – everything from blue-chip stocks to less liquid securities such as junk bonds and leveraged loans.

At the click of a button, investors can buy or sell whole portfolios of assets that were difficult or expensive to obtain. Want exposure to a bunch of lithium mining companies? European covered bonds? Frontier markets? There is – to paraphrase Apple’s marketing slogan – an ETF for that. (In fact, there is even an ETF for apps, via the First Trust Nasdaq CEA Smartphone Index.)

Yet nothing in life comes for free and ETFs rely on a complex ecosystem of financial firms to make their particular brand of liquidity magic happen.

“Authorised participants” are essential to building the funds since they create and redeem the ETF shares, usually in exchange for baskets of the underlying securities, from the ETF sponsor.

They typically sign on to support ETFs because they can eke out profits on small differences between the price of an ETF’s shares and the price of the underlying securities being tracked. If the value of these securities falls below the value of the ETF’s shares, then APs will theoretically be incentivised to buy the basket and deliver it to the sponsor in exchange for shares of the ETF.

The worry is that this market-making dance may come to an abrupt halt at times of market stress – particularly for certain asset classes where investors may be using ETFs to compensate for a lack of liquidity in the underlying assets.

The average weekly volume of high yield and investment grade bonds has fallen 6 per cent since the “taper tantrum”, which began almost exactly a year ago, and caused fixed income investors briefly to flee markets. It also memorably caused two ETF players to curb redemptions on some fixed income ETFs, in other words stop exchanging securities and cash for ETF shares. As the Eagles song goes: “You can check out any time you like, but you can never leave.”

Yet the tantrum had little effect on investors’ appetite for such ETFs – trading volume in high-yield ETFs has risen 18 per cent since, suggesting investors may be using the vehicles to make up for illiquidity in the underlying market.

Every investor should be factoring in a potential illiquidity premium when they are thinking about purchasing less liquid assets such as corporate bonds where, for a variety of reasons, the secondary market is now a shadow of what it once was.

And yet it is doubtful whether that is being done in the case of ETFs, whose allure is largely predicated on the promise of a cheap and never-ending stream of liquidity that happens behind Wall Street’s closed doors.

The same could of course be said for many bond mutual funds, whose rapid growth has already begun causing concern among some regulators and institutions who fear the potential impact of a mass exodus. When it comes to ETFs, however, criticism has been sparse.

BlackRock, one of the world’s biggest ETF sponsors, argued shortly after the taper tantrum that “more and more ETFs are becoming the true market, particularly when market sentiment shifts fast”. It was supposed to be reassuring, but sounded oddly similar to arguing that ETFs have simply become more liquid than the underlying market.

ETF proponents argue that the probability of investors “getting stuck” in the funds during periods of market stress is remote. There are often dozens of market-makers and APs for each fund who are incentivised (but not legally obliged) to create and redeem an ETF’s shares.

If, as the ETF industry states, there is little likelihood that ETF investors will not be able to exit their investments during bouts of market volatility, then the question becomes at what price will they be able to do so? APs are there to make a profit and in times of stress they will no doubt be looking for a very high profit indeed.

“You can check out any time you like, but you can only leave by paying a massive exit fee” might not be as memorable as the Eagles’ lyrics, but it may well be the tune investors are humming when the market next gets the “Mercedes Bends”.



About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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