Over the last several months, financial advisors and ETF Strategists alike have taken calls and engaged in conversation with investors related to billionaire-investor Carl Icahn’s claims of a coming blood-bath in fixed income ETFs. Mr. Icahn’s position is that these fixed income ETFs take what are generally low-liquidity bonds and combine them into high-liquidity ETFs which can be readily traded throughout the day. And that by doing this, on any given day, the historically skittish individual investor will en-masse decide to dump their holdings at a time when there are few buyers. But he has no facts to support that these investments would be impacted more significantly than any other investment under the same market pressure.
To be sure, Mr. Icahn has gotten far more press coverage of his alarmist views than have those who disagree with him such as Blackrock’s (BLK) Larry Fink. And, Mr. Icahn isn’t alone in his position. In fact, the Wall Street Journal reported in July that Mr. Icahn had an unlikely ally for ETF criticism in PIMCO co-founder Bill Gross who now runs the $1.3 billion Janus Global Unconstrained Bond Fund. (JUCIX). On the surface it appears Messrs. Icahn & Gross could have a point. After all, couldn’t the very act of creating a high-liquidity vehicle (the ETF) out of a low-liquidity vehicle (bonds or loans) itself present some amount of danger to investors? Considering Mr. Icahn’s well published short positions in high-yield and Mr. Gross’s lack of an ETF offering, it’s reasonable to ask whether these two well-known investors are just “talking their books”.
Those who criticize ETF liquidity by pointing to those few moments of dysfunction on August 24, 2015 are missing the bigger point. Most investors are not high frequency traders who need a market to trade around the clock. What they need is a fair and honest marketplace where they can acquire or dispose of financial-assets held for long-term investment purposes. ETF Strategists generally invoke long holding periods for their investments. If there is an occasional dislocation in the marketplace, they simply would not trade during that period. Sort of like Sunday or Thanksgiving when the market is closed. The dislocation of August 24th was a non-event for professional ETF Strategists and for the (likely) 99% of ETF investors who did not need to trade during the small window of time that day. The damage, if any occurred, was limited to those foolish enough to have been lured into a false sense of security by stop-loss orders placed at the market.
But what about the “blood-bath” argument? As the theory goes, there will be a stampede of investors looking to unload their high-yield or bank-loan ETFs such as SPDR Barclays Short-Term High-Yield ETF (SJNK) or PowerShares Senior-Loan Portfolio ETF (SRLN). It is important to recognize that both high-yield and senior-loans are subject to the forces of supply and demand on any given day, so prices can and do go up and down. When supply increases and demand decreases, prices go down. The ETF structure does nothing to change that dynamic. In fact, in times of downward price pressure of the underlying assets, one could argue that the ETF itself becomes the price discovery mechanism, because it has more trading volume and a readily quoted market price. The market price can obviously differ from the prior day’s net asset value (NAV) or the intra-day net asset value (INAV), but that doesn’t mean the price is broken, in fact it means the opposite. The ETF market price actually gives the investor a sneak-peek at what is likely to happen to the prices of the INAV, NAV and underlying portfolio holdings as they are priced and traded. In this way, ETFs make markets more efficient, not less.
Looking at some more popular high yield ETFs disproves the Icahn argument. The historic average spread between closing market price and ending INAV for high-yield ETFs has been negligible. The SPDR Short Term High Yield ETF (SJNK) has had an average closing price that is $0.45 above the INAV. Even during times of stress the worst end of day discount the SJNK ETF shares closed at was a mere 2.3% on June 24, 2013. Similarly the iShares High Yield ETF (HYG) has traded at an average closing price $0.20 above its INAV with its worst end of day discount at 7.9% occurring October 20, 2008, one of the darkest days of the global financial crisis. While the discount that day was large it is far more logical to assume the INAV was wrong that day, than to assume the ETF pricing was broken. Further within a matter of days the discrepancy had vanished. ETFs became the price discovery mechanism during crisis, enhancing market liquidity and efficiency.
It is difficult to figure out where Mr. Gross is coming from. Is he trying to say his antiquated mutual fund structure is superior to that of an ETF? The Gross-Icahn argument is like saying you shouldn’t fly on commercial aircraft because there was a crash once. It is literally that illogical.
To be sure, there are plenty of risks in high-yield ETFs and Bank-Loan ETFs. Plenty of things can drive down the price of an ETF, and investors can lose money. With non-investment-grade bond and loan ETFs shares drop when spreads to the 10 year US treasury widen. That is certainly the case today but it seems largely driven by the energy and mining sectors where prices of their product have dropped rendering debt service and payback questionable. Attributing a price adjustment of a well-functioning efficient market to the superior structure of an ETF is an argument left wanting.