`Hero or Villain' Bond ETF Debate Rages on the Milken Sidelines

(Bloomberg) -- Few financial products divide investors more than exchange-traded funds.

While they’re beloved by mom-and-pop buyers for their low cost and ease of use, some professional money managers have called ETFs “weapons of mass destruction” and complained that they’re worse for society than Marxism.

So it came as little surprise that the concerns of the active investing class -- which is having a hard time keeping pace with index-based instruments like ETFs -- bubbled to the surface at this week’s gathering of the financial establishment at the Milken Institute Global Conference in Beverly Hills.

This time around, the worries featured leveraged-loan ETFs, the impact of debt funds on the price of the underlying credit, and whether they drive volatility in bonds. Although ETFs own just 1 percent of the overall fixed-income market, as a BlackRock Inc. report showed last year, these fears are getting increasing attention as the funds grow and some analysts predict an end of the credit boom.

`Hero or Villain' Bond ETF Debate Rages on the Milken Sidelines

“Even though they are small in terms of assets, they handle a lot of the volume of the market, and our market is very one-way most of the time now,” said John McClain, a portfolio manager at Diamond Hill Capital Management, which managed $22 billion as of March 31. “What happens when we have a more meaningful correction this time around? Yes, they’ve handled the volatility so far, but it won’t take a 2008 to crack them.”

Loan Fund Risks

Debt ETFs have ballooned to more than $600 billion in the U.S., doubling their assets from just five years ago, data compiled by Bloomberg show.

`Hero or Villain' Bond ETF Debate Rages on the Milken Sidelines

Loan ETFs pose a real problem because they promise investors immediate liquidity, which the underlying loans don’t deliver, Scott Minerd of Guggenheim Partners, said at the Milken event. In addition, credit prices are often propped up by ETF buying, according to Michael Hintze, founder of the hedge fund CQS, while Ilfryn Carstairs of the investment manager Varde Partners said the funds could accelerate volatility -- in either direction.

The largest junk bond ETF -- the iShares iBoxx $ High Yield Corporate Bond ETF, which trades as HYG -- has oscillated between large flows into and out of the fund this year, including four weeks when investors pulled out more than $500 million and three weeks when they added more than $500 million.

However, that’s not uncommon for HYG, which is often used as a hedge or short-term bet rather than a buy-and-hold investment. As such, its flows aren’t necessarily indicative of sentiment in the high-yield market. For example, short interest as a percentage of HYG’s shares has risen to 29 percent, Markit data show, even as more than $1 billion has flowed into the fund over the last week.

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