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Last updated: June 27, 2013 1:42 pm

ETFs under scrutiny in market turbulence

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Like a tremor that rattles the girders of a gleaming skyscraper, a market sell-off can be the moment that exposes flaws in the plumbing of Wall Street’s favourite products.

For exchange traded funds, a $2tn industry that has boomed in recent years, last week’s tumble in asset prices has unearthed possible cracks in the pipework. Commentators are probing beneath the surface to look at how ETFs, which allow “mom and pop” investors instant access to a multitude of assets, hold up when faced with market turbulence.

Flaws in the plumbing?

Flaws in the plumbing?
ETF creation and redemption

Last week two of the big financial companies that support ETFs curbed “redemptions” on some of the funds. The move has raised concern about the intricacy of the products, which rely on the involvement of a multitude of Wall Street firms.

ETFs seek to replicate the returns of different types of securities or indices while trading on exchanges just like stocks. Their rapid growth has allowed retail investors the ability to dart in and out of a range of funds that track everything from commodities to US municipal bonds.

The products may sound simple, but creating liquid funds out of potentially illiquid securities is complex.

Leading ETF sponsors such as State Street or BlackRock iShares rely on so-called “authorised participants” (APs), typically big banks such as Goldman Sachs and Morgan Stanley or large trading firms, to help launch and sustain the funds.

When an ETF sponsor wants to create more ETF shares to be traded on an exchange, it hands the shares to APs who then deliver a basket of the ETF’s underlying securities to a trust held on behalf of the sponsor. Small discrepancies between the price of the underlying securities and the ETF shares draw APs into making markets, providing an opportunity to make money by “arbitraging” the difference.

“The goal is obviously to not pay more for the ETF [shares] than you get when you sell the [underlying assets],” says one AP. When ETF shares are sold by investors, or “redeemed”, the APs take the shares back to the sponsor, which then hands the participants the underlying securities or cash.

The worry is that APs and other market makers may no longer be willing to support ETFs in volatile markets that may make it difficult for them to offload increasingly illiquid securities. In other words, market conditions could, in effect, impair the “arbitrage” incentive that encourages many firms to support ETFs.

Two recent developments have added to this concern; the explosive growth in ETFs that track fixed income and the reduced role of banks in dealing bonds.

Investors have poured $1.21tn into fixed income ETFs and mutual funds over the past three years, according to TrimTrabs data, as they rushed to take part in one of the greatest ever bull runs in debt. But in the recent bond sell-off triggered by fears the US Federal Reserve will wind down its emergency asset-buying programme – “quantitative easing” – that trend has reversed. Bond ETFs have lost $8.9bn this month, says the research firm.

At the same time, banks say they have been forced to cut positions because of new regulations that make it more expensive to hold the debt. Their bond inventories have fallen 77 per cent from a 2007 peak of about $235bn.

There is no getting around the fact that ETF spreads will widen when liquidity dries up or investors rush for the exits in illiquid sectors

- John Spence, who writes an ETF industry newsletter

Wesley Sparks, head of taxable fixed income at Schroders says: “When an ETF provider or mutual fund has redemptions, they have to do the trade in order to raise cash. If a dealer [bank] is not there to take down a block [trade] of $10m . . . it creates a situation where it’s difficult to raise the cash fast enough.”

At the height of last week’s turbulence, Citigroup suspended redemption orders on ETFs. The bank acts as an AP and market maker for funds, but bumped up against internal risk limits in the sell-off and has since said it was re-evaluating them. State Street, which sponsors dozens of ETFs, stopped offering cash redemptions for the APs of some of its municipal bond ETFs. It says ‘in-kind’ redemptions for the underlying securities never stopped though.

“By no means was anyone going to be stuck in the [ETF] product,” says one AP of State Street’s decision, noting there remain other ways to redeem ETF shares. “It just takes a little bit of liquidity away because one of your options is gone.”

APs and ETF sponsors say it is unlikely that all of the financial companies that make money from supporting the funds would disappear en masse from their role in supporting ETFs. When Citi stopped redemption orders last week, other APs, including Credit Suisse, stepped in, people familiar with the situation say.

Instead, they say, the recent hiccups in some ETFs reflect the potentially worsening condition of the underlying markets they seek to track.

“Investors need to keep in mind that the ETF structure doesn’t magically protect them when the asset class they’re tracking is stressed,” says John Spence, who writes an ETF industry newsletter. “There is no getting around the fact that ETF spreads will widen when liquidity dries up or investors rush for the exits in illiquid sectors.”

But Harold Bradley, former chief investment officer of the Kauffman Foundation and co-author of a 2010 report that was critical of ETFs, remains a vocal opponent. Wall Street “always uses some stretched and fuzzy math to transform illiquid hard-to-trade securities into liquid instruments. Somehow, it always seems to turn out the same way.”

Additional reporting by Michael Mackenzie in New York.


Letter in response to this report:

Cold feet that can freeze a market / From Mr Jonathan P Kahn

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