“The ETF can’t be more liquid than the underlying, and we know the underlying can be become quite illiquid” - Howard Marks
There’s been quite a bit of spirited discussion this year about whether ETFs provide liquidity. The proliferation of exchange traded bond vehicles and the concurrent decline in dealer inventories has led some to question whether investors are being lulled to sleep by so-called “phantom liquidity.”
Barclays took a close look at the issue recently and discovered that since 2009, the “net” portion of gross bond ETF trade volumes had declined from over 20% to just 12%, which the bank cites as evidence that ETFs are adding liquidity to the market.
But this could simply reflect the fact that volumes for ETFs that track assets like junk bonds have skyrocketed over the same period, with low yields fueling both the supply and demand side of the equation and thereby increasing the likelihood that flows will be diversifiable (versus unidirectional).
The problem, as we’ve been keen to point out over the last several months and as noted earlier today [7] is that "when fund flows are one-way (i.e. everyone is selling), fund managers must either i) meet redemptions with cash, or ii) trade the underlying securities. Note that the latter option is so undesirable in illiquid markets (indeed, trading large blocks in illiquid markets poses a systemic risk), that some fund managers are now lining up emergency liquidity lines with banks so that they can at least meet an initial wave of selling with cash and avoid, for a time at least, sparring with illiquidity."
Consider the above and then consider the Global X FTSE Greece 20 ETF which traded on Monday despite the fact that the market for the underlying securities isn’t just illiquid — it’s closed. Bloomberg has more [8]:
Shutting down the Greek market has trained attention on exchange-traded funds tracking its stocks, adding an element of speculation to their prices as long as the Athens bourse is closed.
In the U.S., owners of the Global X FTSE Greece 20 ETF will have less information in deciding how much the security is worth. It tumbled 17 percent. In Europe, the Lyxor ETF FTSE Athex 20 plunged on one exchange and was halted on two others. Trading on the Athens Stock Exchange was suspended until July 6 as the country moves to avert the collapse of its banking system.
[9]
Traders will price the ETFs “on the information they have in front of them, and what they have is limited,” said Kevin Kelly, chief investment officer at Recon Capital Partners in New York. “Investors or advisers need to be prepared for how this is actually going to affect their portfolio.”
While a minor plot in the larger Greek saga, the ETFs have captivated investors in recent months as they looked to express views on the future of its markets. When Egypt’s exchange was shut for two months during the Arab Spring uprising in 2011, investors bid up the Market Vectors Egypt Index ETF only to see it plunge when the exchange reopened.
In a prospectus published on its website, Global X noted that it may be unable to buy or sell securities or financial instruments should an exchange or market close. The fund may be unable to price its investments and could incur trading losses in such circumstances, it said.
While owners of country ETFs often must guess whether stocks will rise or fall when overseas exchanges are closed for holidays, forecasting a market as volatile as Greece, particularly if the halt is extended beyond a day or two, presents special challenges.
Yes, “special challenges.” Another “special challenge” is determining exactly how it is that the issuer is able to satisfy net flows (i.e. nondiversifiable flows) in a market where many of the underlying securities simply aren’t trading.
For the companies that manage the funds, an extended closure complicates the process through which they balance supply and demand for ETFs in one market while keeping its prices aligned to trading levels in another.
Normally, when demand grows for an ETF, its overseers issue new shares to institutions in exchange for bundles of the stocks or other assets that underlie it. In the case of the Market Vectors Egypt Index ETF, that process was halted by the security’s adviser for almost two months while Egypt’s exchange was closed.
So for those trading GREK, understand two things: 1) ETFs, as good as they are at giving investors an illusion of daily liquidity, cannot truly be more liquid than the underlying assets they reference, and 2) trading GREK is now like trading a CEF. If nothing else, these are things all the BTFD'ers should understand before taking the plunge and betting on a "Nai" Greferendum outcome.
