In The Lessons of History, Will Durant presents the seemingly unchanging nature of human behaviour: we are prone to believe that what happened in the past will continue into the future and we tend to fail to learn from previous mistakes. As the The Economist’s essay entitled The Slumps that shaped modern finance, published in April 2014, these psychological nuances of human nature are colourfully expressed in the long history of financial crisis. The essay not only shows how at the bottom of each financial crisis, leaving aside the economic reasons which they caused it, the same feelings of fear and greed collide to change the fabric of markets but it also makes one crucial point: ‘ a well-tuned’ financial system makes an uncertain world more predictable. It is the aspect of predictability that ETFs can put in danger due to their structure.
As our society progressed, evolved and discovered more, we have developed new technologies and new financial instruments. More importantly, we have pushed the boundaries of financial engineering by combining digital technologies with the financial markets: nowadays, investors can choose from a wide and sometimes confusing range of assets – equities, commodities, fixed income products, index trackers, mutual funds, open and close ended funds and exchange traded products are some of the asset classes that are available. One particular name has managed to do financial engineering better than any other institution: BlackRock.
Founded in 1988 by Laurence D. Fink, once one of the key partners at private equity group – Blackstone, BlackRock started as a risk management and fixed income institutional manager. Nowadays, it is the biggest asset manager and the largest ETF provider in the world through its iShares brand.
In the summer of 2015, BlackRock’s high-yield (or junk) ETFs have come under attack by the activist investor and corporate raider, Carl Icahn, for endangering the stability of the markets and therefore, for being a potential cause for the next financial crisis. On December 11, 2015 Carl Icahn spoke on CNBC’s Fast Money on junk ETFs and said:
“It is simple self-evident (that) the high-yield bond market is just a keg of dynamite that will sooner or later blow up.”
Here is his argument:
Carl Icahn says in a video posted on carlicahn.com that the high-yield market is in a bubble: it keeps going up and up with near-to-0 interest rates in the background. He suggests that the loose monetary policy, particularly in the US is driving equity and bond markets to be over-valuated. Against this background he criticised BlacRock (amongst other asset management firms) for selling ETFs that give an illusion of liquidity for ‘extreme illiquid and extremely overpriced’ securities such as high yield bonds. Mr. Icahn made public comments on this subject during the CNBC Institutional Investor Delivering Alpha Conference where he told BlackRock CEO, Mr. Fink, that such products [junk ETFs] are ‘extremely dangerous’.
Naturally, Fink disputed the characterisation. He replied by saying that ETFs create more price transparency than anything that’s in the bond market today:
To trade an ETF at every minute of every day you need to have a valuation of every bond at every minute.
However, the real danger comes from the ‘secret’ sauce that makes ETFs work: the ‘creation/redemption’ mechanism. When an ETF is created, the company, in this case BlackRock, goes to an Authorized Participant (AP) which in turn will buy the underlying assets that ought to be tracked by the ETF and deliver to BlackRock. In return, BlackRock will give the AP a block of equally valued ETF shares priced based on the NAV. The AP plays an important role in stabilizing the differences from NAV and the market price. However, when investors look to redeem the AP will step in to process redemptions. Therefore, the first issue is liquidity: Just how liquid is the HY market? Can it support high demand for redemptions?
In order for the ETF shares to gain monetary value, a transaction must take place: going back to basics Ray Dalio in How the Economic Machine Works clearly explains that our economy (the totality of our markets) works on a multitude of transactions taking place – they are the tools that transform value into money and vice versa. Therefore, who will buy large pools of bonds that are toxic and on the verge of default? Who will be the lender of last resort? Who will take the hit when millions of USD will be redeemed as a result of investors’ lower appetite for junk bonds? These are the some of the questions Icahn was asking Fink and other asset managers.
Recently, on December 11, the world has witnessed junk bond funds ending down by 2%. This small number is actually impressive when you look at how much the US HY mutual fund industry has grown in the past 14 years: from just over $100bn in 2001 to around $400bn in 2014, according to the Financial Times. Moreover, JP Morgan forecasted that the default rate for the energy companies will hit 10% in 2016, 3 times more than in 2015. Therefore the question of liquidity boils down not to: ‘Is there enough junk debt in the market for investors to buy or sell?’ But rather to ‘Who will exchange the underlying debt for the right amount of money?’
Howard Marks in March 2015 published a brilliant Memo on Oaktree Capital Management’s website on the topic of liquidity. He said that sometimes liquidity is thought to be the quality of something for being readily saleable or marketable. However, the more important definition of liquidity is:
“The degree to which an asset or security can be bought or sold without affecting the asset’s price.”
Thus the key feature is not ‘can you sell it and to whom?’ but ‘can you sell it at a price equal or close to the last price?’ Again, the key to understanding this financial concept lies within the realm of psychology: liquidity is the result of investors’ emotions: they take great pleasure in buying things that rise in price and in selling assets that fall. However, what happens when the opposite happens, i.e. when you want to sell something that is falling? That asset tends to become illiquid because the buyers become a minority in the market.
Moreover, liquidity depends on the quantity of the asset. Trying to buy something that is scarce can prove to be very difficult and thus illiquid. More importantly, Mr. Marks stated:
‘Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell decreases (because everyone else has also become afraid to hold it). Thus things tend to be liquid when you don’t need liquidity and just when you need liquidity most, it tends not to be there.’
According to Wells Fargo, the market for junk bonds is around $1 trillion. From this amount, the ‘troubled’ industries such as energy (oil and mining more specifically) amount to roughly $225 billion – not a worrying size for the investors. However, it will depend on how much exposure your ETFs (or mutual funds) have to these unsafe industries.
Secondly, the debate focuses on a question of illusion: Are we in a bubble in the HY market? Bubbles form when there is a substantial divergence between the price, value and quantity of an asset class. This problem can be found in the history of financial crisis where again, the same forces, greed and blind optimism, are driving the junk bond ETF markets.
Additionally, bubbles tend to arise from euphoria and psychological deception that the past will continue ‘at least for the foreseeable future’. Not long ago, the world felt the wrath of the dot.com bubble bursting. That bubbled formed because ‘investors’ were valuating internet based companies too high. Similarly, the HY bond markets have been growing across the world.
For example, if you look at the 6 HY iShares ETFs, they have all enjoyed impressive growth for the past five years. However, due to recent events that have punched through the illusory state, all 6 ETFs have slightly declined. Critically, if they continue to decline, i.e. if redemptions continue to rise, the financial world needs to consider where all this junk debt is going – without a clear, structured and well regulated solution, I am afraid that Carl Icahn is right in saying that HY ETFs can endanger the fabric of the financial system.