ETFs and the Danger of an Illiquidity Doom Loop

(Bloomberg Businessweek) -- Exchange-traded funds have been taking a bigger role in financial markets in the past decade. So it should come as no surprise that they’ve also been featured players in the rolling market dramas that have accompanied the coronavirus crisis.

ETFs are funds that trade throughout the day like stocks. When an ETF owns widely held, heavily traded securities such as the stocks in the S&P 500 index, it runs almost seamlessly. Things can get trickier when an ETF holds more complicated assets or markets get stressed.

Consider oil ETFs such as United States Oil Fund, ticker USO, that invest in oil futures contracts. They made it simple for ordinary investors to bet on changes in oil prices and became so popular they’re a major factor in the futures market. USO recently held about a quarter of a key U.S. futures contract on the Nymex exchange.

As the oil market collapsed, USO’s price has fallen almost 80% so far this year. But USO has also become increasingly untethered from the prices it’s designed to track. The chance to buy oil at ultralow prices drew so many investors looking for a rebound—and likely some short sellers, too—that USO reached the limit of shares it was authorized to issue. With so much demand, its shares began to trade for more than the value of its portfolio. In a move to reduce its risk, the fund also rejiggered its strategy, shifting more money into contracts expiring in later months. This underscored that the fund isn’t a simple bet on headline oil prices but an investment in a complex futures market. “The majority of retail investors in this product probably had no idea what these nuances are,” Ben Johnson, Morningstar Inc.’s co-head of passive strategy research, told Bloomberg News.

Before the oil crash came the liquidity crunch in bonds in mid-March. Trading in many debt securities essentially froze up as markets first reacted to worsening news about the pandemic. But investors continued to buy and sell ETFs that invest in bonds. Normally, ETF share prices very nearly match the value of the securities in their portfolios. Specialized traders earn a profit for keeping things in sync. When fund prices fall, they’ll buy some up and redeem them with the issuer in exchange for a matching set of bonds, which they can then sell.

In March those traders became afraid of getting stuck holding hard-to-trade bonds. “They required a bigger and bigger discount before they would jump in to redeem shares,” says Dave Perlman, an ETF strategist at UBS Global Wealth Management. The $51 billion Vanguard Total Bond Market ETF closed a record 6.2% below its net-asset value on March 12, while BlackRock Inc.’s $70 billion iShares Core U.S. Aggregate Bond ETF closed at a 4.4% discount. The situation didn’t last long. The Federal Reserve surprised markets on March 23 with a decree that it would buy corporate bonds and even some ETFs to pump liquidity into the system. As bonds traded more easily, the discounts disappeared.

Critics have warned of a possible “illiquidity doom loop,” as investors in falling funds run for the exits and exacerbate a sell-off. But others argue the bond episode proved the funds’ usefulness. When markets were gummed up, they say, ETFs became a tool of price discovery—that is, they may have better reflected demand than the prices of thinly traded bonds did. And the ETFs gave investors who really wanted to sell a way to do so. “It was not an exit route that didn’t have a lot of big potholes in it,” says Ed Keon, chief investment strategist at Quantitative Management Associates. “But at least you could get out.”
Read more: The Oil Price Crash in One Word: ‘Inelasticity’

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