When the market is awash with liquidity it is easy to forget how quickly things can change. With the onset of the financial crisis now five years ago, the old adage that the market has a very short memory seems to be holding true.
The defining characteristic of late 2007 was the evaporation of short-term liquidity to funding vehicles that had used it to acquire long-term assets. The fallout from this liquidity mismatch was swift and brutal.
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As the credit markets again succumb to irrational exuberance, they are telling themselves that things are different this time. The excessive leverage that had built up in the system before 2007 is not there: the investors bidding those crazy prices in the market are real-money buyers, so there is nothing systemic to worry about if and when the market turns.
There may not be any more SIVs and ABCP conduits out there, but there are now a huge number of investment vehicles carrying just the same kind of liquidity mismatch that their ill-fated predecessors did and vulnerable to the same kind of shocks when interest rates start to rise: exchange traded funds.
According to EY, by the end of October 2013 the global ETF industry consisted of 5,042 funds, with 10,053 listings and assets of $2.3 trillion from 215 providers on 58 exchanges.
That is a lot of money. Clearly not all of these funds run a worrying liquidity mismatch, but there has been a sharp growth in those investing in relatively illiquid assets such as high-yield bonds as the reach for yield has intensified. According to BlackRock, $35 billion of high-yield debt is now held in ETFs. Assets in the largest 10 high-yield dollar ETFs have grown 24% over the past two years.
Just how destabilizing might this be when the market turns? These funds offer daily liquidity while tracking an index based on securities that are essentially illiquid. The taper tantrum of May and June 2013 provides the best indication of how things might play out. It does not bode well.
On June 3 2013, $1.3 billion of BlackRock’s $14 billion iShares iBoxx US$ High Yield Corporate Bond ETF changed hands on just one day. Over the course of the two months a total of $5 billion was withdrawn from such ETFs. The industry points out that far more was withdrawn from mutual funds during that period.
However, it is hard to dispute that ETFs will be a driver of volatility when markets eventually turn. According to Credit Suisse, the dollar percentage of ETF trading can top 40% when markets are turbulent, and BlackRock calculates that ETFs accounted for roughly $1 of every $3 in trading volume in US equities in June last year.
Some high-yield investors are specifically seeking out high-yield bonds not held in ETFs to cushion volatility when the exit comes. That certainly seems to be a wise move, but one that might be difficult to execute given the nature of the market and how it has developed. Everyone else will just have to hold onto their hats and prepare themselves for what will likely be a bumpy ride.