ETF liquidity a growing point of financial industry contention

Little to indicate the ETF industry is fully prepared for a major rush to the exits by investors.

For a lot of financial advisers, the primary appeal of exchange-traded funds boils down to low fees and liquidity. There is no disputing the low fees, which provide investors with varied and broad market exposure for mere basis points, in most cases. But the liquidity has become a growing point of contention throughout the financial services industry and is something advisers using ETFs need to follow.

What some see as a benefit, others see as a misleading, and even dangerous, trapdoor.

Last month when Tangent Capital chief investment strategist Bob Rice sounded the alarm about ETF liquidity in an opinion piece for InvestmentNews, the volume of the debate was turned up another notch.

Much of what Mr. Rice presented centered on the illogical reality that many ETFs are dramatically more liquid than their underlying portfolio holdings, which is part of a steady drumbeat from a range of informed skeptics and critics.

“As ETFs may appear to offer greater liquidity than the markets in which they transact, their growth heightens the potential for a forced sale in the underlying markets,” according to a February report from the Federal Reserve.

Well-known investor Howard Marks agrees: “The ETF can’t be more liquid than the underlying.” And activist investor Carl Icahn described the situation as “phantom liquidity” and a “keg of dynamite.”

Various publications have challenged the asset management industry to address or at least acknowledge the disconnect between an ETF that trades throughout the day and an underlying bond that might trade once every few months.

The risk of a liquidity snag seems apparent. If enough ETF investors want to sell in a hurry, will some of the more obscure, difficult-to-trade or foreign securities have the liquidity to enable appropriate liquidity at the ETF level?

A LOT OF TRUST

Mr. Rice contends most ETF investors aren’t worried because they either don’t fully understand the way an ETF works or are willing to place a lot of trust in the asset management industry’s promises that there is nothing to worry about.

Financial institutions known as authorized participants create and redeem shares, and ensure the ETF price stays in sync with the net asset value of the underlying securities. In essence, they are the gears of ETF liquidity. Authorized participants are motivated to do this by the profits gleaned from trading the underlying ETF securities.

Last summer, the system designed to keep ETFs liquid while keeping share prices in line with NAVs was tested, and in many respects it failed. On Aug. 24, a chain of events that triggered trading halts in just eight S&P 500 stocks led to a liquidity traffic jam for 42% of all U.S. equity ETFs. For example, the price of the Vanguard Consumer Staples ETF (VDC) reportedly fell 32% while the underlying holdings dropped just 9%.

As the mayhem unfolded, authorized participants largely stepped back and watched the carnage, while some investors were forced to absorb the pain.

Theodore Feight, owner of Creative Financial Design, recalled seeing stop-loss orders set to sell at declines of 15% not kick in until prices dropped by 30%. He said his clients lost $5.5 million in the first three minutes of trading on Aug. 24, and he has since sworn off using stop-loss orders for ETFs. Perhaps most scary is that in an report released Dec. 30, the Securities and Exchange Commission detailed what happened Aug. 24, but acknowledged it didn’t fully understand what caused it.

ISSUES AROUND THE EDGES

The Investment Company Institute has challenged critics of ETF liquidity by addressing issues around the edges of the debate, including suggesting that ETF trading on the secondary market has contributed to the liquidity.

Ultimately, there is little to indicate the ETF industry is fully prepared for a major rush to the exits by investors. That means the best that advisers can do is keep clients in ETFs that have the most liquid underlying securities and steer clear of stop-loss orders.