Gumby, Space Stations, And Things That Make No Sense

Yeah, this is about ETFs.
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If you suggest that something makes no sense and the people who have a vested interest in that something respond by saying that your incredulity stems directly from you “just not understanding” how that something works, there are two possibilities:

GumbyETFs
  1. You really don’t understand how that something works.
  2. That something really doesn’t make any sense.

There’s no in between.

“You just don’t understand” is only an acceptable response to criticism in cases where the person doing the criticizing has absolutely no legitimate claim on an opinion. You can’t, for instance, criticize the design of the International Space Station by saying that it makes no sense for it not to resemble a giant, flying Gumby. There are technical considerations that override whatever joy humanity might derive from knowing that Gumby is perpetually in low Earth orbit keeping an eye on things.

In that situation, the trotting out of technical considerations by rocket scientists isn’t a nefarious effort to keep the public from waking up to some self-evident design flaw (in this case that we’d all be better served if habitable satellites were fashioned to look like pieces of grinning, green Laffy Taffy). Rather, if the end we’re pursuing is a working space station, the means we have at our disposal for achieving that end dictate that it can’t look like Gumby. So to the extent you want to say it “makes no sense” that the design shouldn’t be aimed at maximizing nostalgia for a beloved claymation icon, well, “you just don’t understand.”

In markets, on the other hand, there’s a demonstrable tendency for people to trot out technical considerations not because those technical considerations are the only means we have to achieve some ostensibly desirable end (say, increasing access to the high yield bond market for instance), but rather to obscure the fact that the vehicles we’ve created are inherently dangerous by virtue of not making any sense.

I have been told at various times by multiple people with a vested interest in high yield and emerging market bond ETFs that “I just don’t understand” the financial innovation that somehow allows ETF sponsors to offer intraday liquidity against a pool of assets that are most assuredly not liquid. And I am not alone in being told that I “just don’t understand.”

Let’s be clear: it makes no sense to say that ETFs are more liquid than the underlying. That is a philosophical impossibility. Here’s how Howard Marks put it back in 2015:

What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we're back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can't get away from depending on the liquidity of the underlying high yield bonds. The ETF can't be more liquid than the underlying, and we know the underlying can become highly illiquid.

Right. And see there is no getting around that. It is damn near a tautology.

Carl Icahn - and please, stay on message here and don’t let your thoughts drift to unrelated jokes about Carl - voiced similar concerns in a now infamous roundtable discussion with Larry Fink back in the summer of 2015.

It’s the same story with emerging market debt ETFs which saw massive inflows during the first half of 2017. Asked by FT about the apparent absurdity in asserting that while money coming in equals bond buying, somehow money flowing out won’t equal bond selling, iShares’ Brett Pybus had this to offer:

People say ETFs will be forced sellers [in a falling market] but that’s not the experience. ETFs are far more likely to adjust their holdings in kind, by handing over bonds to authorised participants than by selling bonds for cash.

If that sounds like someone trotting out technical jargon to get around answering questions about a model that fundamentally makes no sense, that’s because that is exactly what Brett is doing.

That isn’t to say that the mechanism doesn’t normally work. In other words: that isn’t to say that Brett isn’t right under normal circumstances. Rather, the problem is that defenders of the model habitually refer to “normal” market conditions when asked specifically to explain how it would work if the market isn’t functioning normally. That’s a hallmark of obfuscation. If someone asks you what happens to a model when shit hits the fan and your response is to point to how things work when shit isn’t hitting the fan, then you have not answered the question.

To be sure, some of the people in the industry understand this.“If you knew everything was coming up for sale, would you step in?” Eaton Vance’s Michael Cirami told FT, in the same article linked above. “When the redemption basket gets passed on, the person it gets passed to is going to do some fundamental analysis, which the other guy [who bought the ETF] didn’t care about.”

The arb mechanism seems to rest entirely on the notion that there will never been a firesale. No one is going to want to participate in this charade if it amounts to a giant exercise in knife-catching.

As far as I can tell (and I’ve talked to a lot of different people about this, including sellside strategists) this only works as long as the flows are diversifiable. If the flows one day become unidirectional (that is: everyone is selling), then this whole thing collapses, where “collapses” means that common sense reasserts itself and the liquidity of the ETFs converges with the liquidity of the underlying assets. Here’s a very simple explanation from a recent SocGen presentation reiterating exactly that point:

If the underlying exposure is poorly liquid, ETF may offer superior liquidity, benefiting from the liquidity of the order book and the liquidity of market makers. The liquidity benefit of ETF requires the ETF secondary market (on-exchange + off-exchange) to be balanced, e.g. ETF sellers meeting ETF buyers. In case of a one-way market or a selloff, ETF secondary market liquidity might disappear. ETF liquidity could then become equivalent to that of the underlying assets and could be potentially low if these are poorly liquid, which might induce unexpected liquidity costs for investors.

See that bolded passage? You can translate that as: “if shit hits the fan, it could then become clear that the model made no fucking sense in the first place, where that model was based on promising investors intraday liquidity against assets that aren’t liquid.”

SocGen goes on to note that “if the ETF secondary market fully evaporated, it could take more than a week to unwind all outstanding US corporate bond ETF positions based on the underlying market volumes.” Now just try to kind of extrapolate from that what kind of week that would be in terms of utter chaos.

I am fully aware that there will be someone who reads this and makes a mental list of all the things “I just don’t understand” about ETF liquidity. If you’re that someone, please note: there is exactly zero chance that there is anything on your mental list I have not heard and considered at some point over the last two years. And let me tell you something else there is exactly zero chance of: there is exactly zero chance that the majority of people buying high yield and emerging market bond ETFs understand the problem here.

This is a model that makes no sense and by allowing the clueless masses to persist in the fantasy that their high yield and emerging market ETF shares are liquid, it’s the long-held opinion of Heisenberg (who is not an attorney, so no one panic), that ETF sponsors are kinda, sorta committing fraud.

And coming full circle, this is most assuredly not a case where I have no legitimate claim on an opinion. ETF purveyors are not rocket scientists and I’m not insisting on a Gumby-shaped space station. If the aim here is to expand access to the high yield bond market, there are plenty of ways to pursue that end that don’t involve foisting nonsensical business models on unsuspecting investors.

Catch more Heisenberg over at Heisenberg Report.

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