Portfolios of ETFs and Liquidity

I have gotten questions about the liquidity of ETF portfolios, especially in times of market stress. I think they make sense for most investors even taking these risks into account.
 
I think there is decent evidence that liquidity is changing. However, this does not seem to be an issue which is peculiar to of ETFs. On October 15 of last year the treasury market, the most liquid in the world, had moves so extreme the treasury department issued a 76page report on a 10 minute period (Report here. English translation here). While too-big-to-fail banks are quick to blame Dodd-Frank, my reading of the report suggests that market making algorithms and high frequency trading deserves more of the blame. Whatever the cause, let us stipulate that liquidity in many markets has fallen since the financial crisis.
 
I think investors interested in, say, high yield bond exposure are better off in an ETF than they would be in the underlying and doubly so if they need to reduce their exposure quickly.  The ability of ETFs to trade during the day means that by lowering price below fair value, investors in a pinch could induce buyers.  The ability of authorized participates to create and redeem units with the underlying stocks or bonds means that ETFs should not be away from fair value for long.  Conversely, if an investor owns a particular bond, during a crisis they may well have to offer a larger discount to sell it in a hurry than they would the basket of bonds held by the ETF.  (For more on ETFs and Liquidity from an ETF providers point of view, see this note from BlackRock)
 
There is no such thing as perfect liquidity for everyone at the same time an any market. What is the a realistic worst case for portfolios of ETFs?  The first thing to notice is that there is not a mechanism which will force investors to sell at fire sale prices.  While no one wants to panic, some investors can be forced to sell at inopportune times, regardless of price because of leverage or risk constraints.  But if you don’t borrow money for investing, you usually have some flexibility.  Investors who hold ETFs directly and do not use margin can wait for more normal market conditions return before adjusting their portfolios.  What about mutual funds holding ETFs – how could they be hurt if a substantial portion of the fund decides to liquidate?  Moves and redemptions would have to be very extreme to have a noticeable effect on the portfolio.  If, for example, on a day of high illiquidity 20% of a fund redeems and 25% of the fund is in illiquid securities which are undervalued by 5% that would only translate to a 25 basis point loss of NAV if positions were liquidated pro rata. .
 
There is a different, ETF-specific issue that It is possible that unsophisticated investors are buying ETFs whose underlying liquidity they do not fully understand, but it is difficult to see how this is different than many other instruments mom and pop can buy from penny stocks to options.  As always, the products in the marketplace are complex and most investors are well served by seeking advice from a financial advisor. 
 
Overall, at Astor we see liquidity is as another risk factor to be monitored and managed.  We will continue to monitor market developments but today we do not see liquidity concerns as a reason to avoid ETFs.

Jobs day read on the US economy

• My current view of the economy is for continued, modest expansion in the US. The proprietary index we track as a primary gauge was modestly stronger over the second quarter, though still below the levels of the fourth quarter of 2014. Likewise, the Atlanta Fed’s current estimate

Source: Federal Reserve Bank of Atlanta

Source: Federal Reserve Bank of Atlanta


• The jobs market continued to improve in June as 223,000 jobs were added. This measure of employment has been in a fairly narrow range for years and seems unlikely to change meaningfully in the near future. Disappointingly, neither earnings nor hours seem to have increased last month.
• Coincident with the improvement in the economy is an move in expected inflation (as measured by various market measures) back toward the Fed’s long term 2% target. The FOMC members have said that inflation expectations being at the target and employment around potential are the two conditions necessary for rates to be normalized. Inflation expectations were weak in the beginning of the year, and while the Fed claimed to be looking through these readings, they have to be satisfied to see inflation expectations normalize.
Source: Bloomberg, Federal Reserve Bank of Philadelphia, Astor calculations

Source: Bloomberg, Federal Reserve Bank of Philadelphia, Astor calculations


• The view from the rest of the world is not so rosy. Europe continues to choose to allow 1% of the population take up all the time of the leaders of an entire continent. The situation is quite fluid and there do not seem to be any obviously good choices for anyone. The best news for US investors may be that the damage from five year train wreck is probably going to stay mainly on its own track, given the amount of time investors have had to worry.
• Mainly, but not entirely. At Astor we track an index of financial stress (similar to the Kansas City Fed’s Financial Stress Index but compiled on daily data). This index has spiked over the last week. It started at very low levels, however, and is still below where we get concerned but nevertheless it shows that other stress-sensitive spreads reacted as much to the Acropolis Apocalypse than they did to the crude or stock market sell offs in the fourth quarter of last year. Stress seems to be dissipating in the last two days but we will keep a close eye on this indicator.
Source: Federal reserve Bank of Kansas City, Astor calculations

Source: Federal reserve Bank of Kansas City, Astor calculations


• For global growth environment, our GDP-weighted measurement of the PMIs shows most of last month’s improvement was undone, though the measure still shows manufacturers’ orders expanding. The weakness is focused in Asia, with the PMIs for China little changed and the Asian economies whose most important trade relationship is China (Taiwan, South Korea, Australia) showing additional weakness. All three of these economies show shrinking manufacturing orders as measured by the Markit PMIs.
Source: Bloomberg, Markit, Astor calculations

Source: Bloomberg, Markit, Astor calculations


• Overall, the US is continuing to grow in a challenging external environment.