Money Market Funds
Operations and Technology
More Unfounded Speculation on Bond ETFs and Financial Stability
By Shelly Antoniewicz and Mike McNamee
April 13, 2015
A recent column in the Financial Times warns of “another accident in waiting” in the growth of fixed-income exchange-traded funds (ETFs)—described as “financial alchemy” that converts illiquid bonds into “baskets” that “trade moment to moment on the stock exchanges.” This “illusory” ETF liquidity will disappear, the author warns, when investors “want to move en masse, and quickly, when the going gets less good.”
There they go again. The column commits at least three fundamental errors.
First, the FT column’s central premise is this statement: “No investment vehicle should promise greater liquidity than is afforded by its underlying assets.”
Yet a 30-year Treasury bond promises greater liquidity than a claim on $10,000 of Uncle Sam’s assets that can’t be redeemed until 2045. A share of Citigroup stock promises greater liquidity than a 1-in-3 billion ownership stake in Citi’s loan portfolio. A pork belly future certainly promises much greater liquidity than 40,000 pounds of bacon—not to mention fewer shipping hassles and refrigeration challenges.
Since long before Wall Street traders gathered in 1792 under a buttonwood tree, financial markets have been creating instruments precisely because they promise greater liquidity than their underlying assets. ETFs may be relatively new—but that doesn’t make their function any different.
Second, the Financial Times ignores the major source of activity in ETFs. It’s not the underlying markets—it’s the secondary market where ETF shares trade.
Our research shows that most activity in bond ETFs occurs on the secondary market—ETF investors trading ETF shares with one another—rather than on the primary market, where underlying securities are used to create and redeem ETF shares. For bond ETFs, on average, more than three-quarters of the daily trading activity occurs on the secondary market (see the figure below).
Even for narrow asset classes, such as domestic high-yield bond ETFs or emerging markets bond ETFs, the bulk of the activity is in the secondary market. Investors involved in many of these ETF secondary market trades generally are not motivated by arbitrage (i.e., the desire to exploit differences between the market price of the ETF and its underlying value). These investors do not interact with the ETF directly and do not create transactions in the underlying bond market because they only exchange ETF shares.
Most Bond ETF Activity Is in the Secondary Market
Percentage of secondary market activity relative to total activity;* daily, January 3, 2013–June 30, 2014
* Total activity is the sum of primary and secondary market activity.
Sources: Investment Company Institute and Bloomberg
What would happen to ETF investors if the underlying bond market locked up? ETF shares could still trade in the secondary market. Indeed, bond ETFs probably would provide price discovery for the underlying market. Investors could continue to express their opinions about what those bonds might be worth by trading the bond ETFs.
Finally, the columnist’s claim that ETF investors will “move en masse, and quickly, when the going gets less good” was tested during the summer of 2013—and disproven. During that summer, bond prices moved sharply downward as the Federal Reserve indicated it might begin to curtail its massive bond-buying program. From May to July 2013, the nominal interest rate on the 10-year Treasury bond rose 90 basis points.
As our research has shown, bond ETF shares were not redeemed to the funds en masse, and secondary market liquidity in bond ETFs did not disappear. In fact, in terms of dollar value traded, there was more demand for liquidity by sellers and more liquidity available from buyers during that period. Even narrower asset classes, such as domestic high-yield and emerging markets bond ETFs, had ample liquidity in the secondary market during the summer of 2013.
Data like these—based on actual market experience—seem to be overlooked by many participants in the debate over financial stability. Fund investors deserve better than unfounded speculation and hypothetical scare stories.
Shelly Antoniewicz is a senior economist for industry and financial analysis in ICI Research. Mike McNamee is ICI’s chief public communications officer.
Once Again, Information Moves Markets
By Sean Collins
March 18, 2015
Treasury yields fell sharply today and the stock market jumped. Wouldn’t it be nice if mutual funds could take credit? Unfortunately, they can’t. Any orders that mutual fund investors place to buy or sell shares anytime today before 4:00 p.m. won’t hit the market until 4:00 p.m., just like any other day. And, if you are reading this blog post at the time of its posting, 4:00 p.m. is still 10 minutes away.
Does Liquidity in ETFs Depend Solely on Authorized Participants?
By Shelly Antoniewicz and Jane Heinrichs
March 16, 2015
ICI recently conducted a survey of its members that sponsor exchange-traded funds (ETFs) to collect information on authorized participants (APs)—typically market makers or large institutional investors with an ETF trading desk that have entered into a legal contract with an ETF to create and redeem shares of the fund.
Plenty of Players Provide Liquidity for ETFs
By Shelly Antoniewicz
December 2, 2014
A recent article in the Financial Times’ FT Alphaville blog (“Lies, Damned Lies, and Liquidity Expectations”) focused on a paper published by the Committee on the Global Financial System, an organization that monitors developments in global financial markets for central bank governors.
Bloomberg Ignores the Evidence on Bond ETFs
By Mike McNamee
September 26, 2014
In response to “Pimco ETF Probe Spotlighting $270 Billion Market Vexing FSB,” we posted the following comment on Bloomberg News’ website:
A Look Inside ETFs and ETF Trading
By Rochelle Antoniewicz and Jane Heinrichs
September 23, 2014
Investors in exchange-traded funds (ETFs) are trading shares with each other far more than they are turning to authorized participants to create or redeem shares.
The Real Lessons to Be Learned from 1994’s Bond Market
By Brian Reid
July 29, 2014
A recent “Heard on the Street” column in the Wall Street Journal (“Heeding 1994's Bond-Market Lesson,” July 27, 2014) is correct in saying that there’s a lesson to be learned from the 1994 bond market—but it draws the wrong lesson.
SEC Chair White Stresses Need for FSOC to Consult Sources for Necessary Expertise
By Rachel McTague
May 22, 2014
Securities and Exchange Commission (SEC) Chair Mary Jo White today called for the U.S. Financial Stability Oversight Council (FSOC) to use outside expertise to the degree necessary in its process of designating systemically important financial institutions (SIFIs). She asserted that it is “enormously important for FSOC, before it makes any decision of any kind, to make sure it has the necessary expertise on any of those issues.”
“Market Tantrums” and Mutual Funds: A Second Look
By Sean Collins and Chris Plantier
May 19, 2014
Over the past year, policymakers who are focused on financial stability have pursued a theory that mutual fund investors can destabilize financial markets by redeeming from funds when markets decline. According to this theory, redemptions by fund investors lead fund managers to sell securities; those sales drive asset prices down further and, in turn, spur more investor flight, redemptions, and price declines.
ETFs Don’t Move the Market—Information Does
By Shelly Antoniewicz
March 11, 2014
There they go again.