ETF industry risks regulators’ attention over institutional block trading, says Moody’s

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An institution making a significant, in-kind redemption from a junk bond ETF this month caused its price to plunge to 1.3% below NAV. This highlights dangers retail investors face when institutions swing in and out of passive vehicles heavily, and could bring increased regulatory attention, says Moody’s.

The passive fund industry has already faced investigation for any disadvantageous role it could play in financial market stability.

This recent ETF trading activity – and including other examples possibly spurred by major investment banks – could see regulators turn on it, to the detriment of fund sponsors, says Moody’s.

The recent example, on 10 May, was for an in-kind redemption of $780m, or 19.7 million shares, in State Street Global’s SPDR Barclays Capital High Yield Bond ETF.

The vehicle’s price was hit to below its NAV by the large block trade, as an additional 14.4 million shares were subsequently extinguished, reducing by 13.4% net assets of the fund.

The share price declined 2.7%, and the ETF’s price plunged to  a 1.27% discount to NAV by 17 May. This compared to a modest, 0.4% premium during the rest of the year.

ETFs should broadly mirror markets they follow, and not trade at a large premium or discount to NAV.

“This collapse in premium would have cost an investor a substantial portion of the year-to-date total return of the ETF, which was 5.9% through 30 April,” Moody’s said.

In addition, open short selling interest in this ETF increased from 3.6% to 4.2% in the month to mid-May.

Moody’s suggested the recent trading activity in high yield bond ETFs “could have resulted from arbitrage opportunities related to anomalous pricing in the credit default swap market created by JPMorgan Chase & Company’s outsized selling of the Markit CDX index.

“Whatever the reason, retail investors in ETFs generally do not expect this type of trading behavior.

“ETFs have been aggressively marketed to retail investors with educational efforts and information-rich websites that enable users to generate comparisons between competitors’ products. As cheap alternatives to actively managed mutual funds, their use is being promoted in retirement plans.

“However, the rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seems to be increasing investors’ risk.

“This development dilutes the marketing message of industry sponsors that have promoted ETFs as a superior investment technology for retail investors, as well as invites additional regulatory oversight, potentially undermining the credit positive benefits ETF sponsors have enjoyed from their success to date.”

Moody’s said the growing institutionalisation of the ETF marketplace was “credit negative for ETF sponsors such as BlackRock with its iShares, Invesco with its PowerShares and State Street Corp with its SPDRs.”

The ratings agency added: “Retail investors and their advisors would be deterred from holding ETFs if they are exposed to elevated volatility and execution risk from large trades.”

They also raise the risk of extra regulatory attention and so increased compliance costs for the products, “if their use as vehicles for implementing arbitrage strategies proves to amplify systemic risks”.

Moody’s described the trade in SPDR Barclays Capital High Yield Bond ETF, which would give the investor control of bonds directly from the fund’s portfolio, as “unusual and it signifies institutional investors’ increasing use of ETFs that have long been marketed to retail investors”.

Whereas retail investors trade ETF shares on secondary markets, larger buyers can trade directly with the fund through in-kind transactions of 100,000-share blocks known as ‘creation units’. These are then exchanged for baskets of securities replicating the fund’s benchmark.

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