ETF liquidity ‘illusion’ alarms managers after volatility spike

Fund managers have voiced concerns ETF trading is increasingly driving the direction of the wider market and exacerbating recent slumps, raising questions over the use of the products in less liquid securities.

The spike in volatility seen last month has drawn attention to the increasingly prominent role played by exchange-traded funds in less liquid asset classes such as high yield debt and emerging markets.

iShares took the unusual step of issuing an open letter to investors last week, in which it noted the “increased focus on how ETFs perform, particularly in stressed markets”.

The provider said ETFs increasingly represent “the true market” in some areas, and noted record levels of daily trading in its US high yield bond and emerging market equity products.

But other investors said ETFs’ rise to prominence had led to more severe market movements, particular in the fixed income space.

“In the US you did notice the larger benchmark bond issues were underperforming, and those were likely to be the names ETFs are centred around,” said Stefan Isaacs, manager of the £1.4bn M&G High Yield Corporate bond fund.

“It does raise the question of whether an ETF is an appropriate vehicle for a less liquid asset class.”

Change of dynamics

Azhar Hussain, manager of the Royal London Global High Yield fund, said ETF flows had exacerbated the recent sell-off.

“ETFs have changed the dynamic. They are only about 3% of the market but they represent a large proportion of turnover. That increases when there is volatility; usually they account for around 10% but in this environment that has risen to 20%-25%,” he said.

 “They claim to offer liquidity in an illiquid asset but it may not work.”

ETFs can increase volatility because investors can offload them so rapidly, and in recent weeks this has caused stresses in markets, with some exchange-traded providers hitting daily limits on the amount of collateral they are allowed to have out in the marketplace.

In the latest sell-off, this has meant some ETF providers have been trying to pay sellers of their funds in bonds rather than cash.

iShares announced last month it is to partner with trading platform Tradeweb to produce a hedging tool that boosts liquidity in fixed income ETFs. In last week’s open letter it said exchange-traded funds “performed precisely as they are designed to” during recent volatility.

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