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.

Don’t Panic

The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?

The fundamental argument for panicking

The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.

The “fear itself” argument for panicking

Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.

Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.

The stronger argument for staying the course

At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.

In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.

Our conclusion: Don’t Panic

Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.