Fed Is Buying Credit ETFs But One Hedge Fund Is Shorting Them

(Bloomberg) -- Adam Schwartz didn’t know a lethal virus more contagious than the flu would spark the biggest credit crash in a decade.

But his hunch that exchange-traded funds would buckle in a major rout is getting some vindication in the industry’s biggest stress test.

The ex-Fir Tree director has staked a chunk of his $13 million hedge fund on costly short ETF positions for years in the belief that the liquidity promised by these funds would ultimately prove illusory.

That bet paid off as corporate bond funds plummeted in recent weeks, in many cases exceeding the declines in their underlying assets. Before the promise of Federal Reserve stimulus spurred a reversal, investors were nursing heavy losses and some were even questioning the soundness of products that have swelled to become an $834 billion industry in the U.S. alone.

Though he declined to say how much he made on his shorts, a slew of Schwartz’s bearish options positions returned as much as 20 times, more than making up for last year’s losses, he said.

Schwartz’s Black Bear Value Partners fund, which also invests heavily in stocks, was down 3% for the month as of March 20, compared with an 8% loss for a global hedge-fund benchmark.

Fed Is Buying Credit ETFs But One Hedge Fund Is Shorting Them

Schwartz, who spent eight years at Jeffrey Tannenbaum’s Fir Tree Partners, has taken some profits but he’s still bearish. The Florida manager remains short credit ETFs -- investment grade, high yield, leveraged loans and emerging markets -- to the tune of nearly half of his fund’s assets by notional amount. That’s even as promised Fed stimulus has sent some of these products rallying.

“There is serious potential economic pain ahead and the companies with weak balance sheets and their debtholders are likely going to have some pain,” said Schwartz, who has the bulk of his net worth invested in the fund.

The sell-off has laid bare the ability of companies to weather a prolonged economic downturn. It’s also exposed the mismatch between credit instruments and the $200 billion worth of ETFs that hold them. Even staid funds like those tracking U.S. Treasuries and municipal bonds traded at historic discounts to the value of their underlying holdings.

Fed Is Buying Credit ETFs But One Hedge Fund Is Shorting Them

Many market players reckon these products performed as advertised. Their argument is that any discrepancy between the value of the ETF and its underlying bonds reflects the price-discovery function of the funds in times when the underlying securities don’t trade.

Schwartz concedes that prices of the underlying bonds may have become stale in contrast to the real-time ETFs. But he has a different takeaway: Passive instruments in relatively thinly traded assets are sold to investors with a false promise of instant liquidity.

“They weren’t safe and there wasn’t liquidity,” he said. “They were a bull-market invention for bond-market euphoria.”

He points to investors who sold the ETFs at stiff discounts to their net asset value as an example. “There were major outflows in the first 10 days or so, and people were getting discounts of 3%, 4%, 5%,” says Schwartz.

All that means he’s a big skeptic of the relentless boom in passive credit products marketed to retail investors.

“You can’t just create liquidity by inserting a market-maker -- you can only create liquidity by having supply and demand that match up,” he said.

©2020 Bloomberg L.P.

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