Much has been written over the years about whether it is possible to marry the ETF wrapper with more illiquid assets amid the well publicised risks of investing in areas such as real estate, private equity and leveraged loans.
The age-old argument persists that liquidity promised through ETFs is illusory and is likely to disappear in times of market turmoil, while many question the reasoning behind eroding the very benefit of an ETF – its secondary market liquidity – by trading more illiquid assets.
Conversely, this is precisely what some investors believe makes it a beneficial instrument for investing up the liquidity premium scale.
As Terry McGivern, senior research analyst at AJ Bell, said: “It is all about price discovery, and ETFs do a much better job than index funds, which give a sense of security.”
This price discovery, McGivern argued, was also apparent during the COVID-19 dislocation last year. Furthermore, a recent report by Citi found ETFs are driving greater transparency in the fixed income market by helping facilitate higher turnover in the underlying bonds through the creation-redemption process.
Despite this, investors remain cautious in combining the two. Flows into alternative ETFs have been modest, rising from €1.6bn to just €2.8bn in the three years since October 2018, still a tiny figure compared to the €1.2trn European ETF market.
However, in today’s low-yielding environment, many investors are climbing the risk ladder in the search for yield, leaving some to fish in the depths of the market with higher liquidity premiums.
On top of this, innovations in areas such as data transparency enabling greater liquidity risk allow investors to better understand the liquidity risks they are taking.
So, is it possible for investors to match up illiquidity and ETFs, and if it is, where and how would it work?
A silent revolution
Put simply, Vincent Denoiseux, global head of ETF research and solutions at Lyxor, would not touch a product that combined the two.
“The terminology of the ETF in an illiquid market sounds odd to me. What the ETF market wants to avoid is typically a case where a company brings a so called ETF that would be deemed to be illiquid because participants are expected to offer a reasonable amount of liquidity.
“There might be an optical perception of liquidity, but in a liquidity test as we observed in the coronavirus sell-off last year…we know if an ETF provider would have launched something illiquid, there would have been a disappointment from an investment perspective,” Denoiseux added.
Despite this resolute view, there are areas of market innovation helping investors better assess the liquidity landscape, giving them access to data on the depth of the market and the number of transactions in the same security.
Olivier Souliac, senior product specialist at DWS, said he believes this data has led to a “silent revolution” – largely driven by the ETF ecosystem – which has, in turn, increased investor appetite for less liquid market segments. “You have transaction data about the volumes, and the frequency gives you also an indication about the immediacy and the tightness.
"You can have 360-degree liquidity assessment for thousands of securities in a completely automated way,” he said.
Secondary to none
One of the most important aspects of why an ETF might work well for more illiquid assets is the secondary market. This is its ability to continue trading with other investors when the stock market locks up to prevent a mass sell-off in times of high market stress.
This was highlighted in 2015 when both the Chinese and the Greek markets locked up, but ETF trading was still taking place on the secondary markets. It is worth noting these trades would have taken place at a steep discount to net asset value (NAV).
However, McGivern said it shows “the NAV was not a true representation of the underlying holdings” and it was down to the ETF to show accurate price discovery.
“The ETF carried on trading and people were able to transact adjusting to the environment that might be 20% down on NAV; however, that is where the market was. When it eventually opened, it matched where the ETF price was,” he added.
A recent research piece by the London School of Economics, ETFs, Illiquid Assets, and Fire Sales, found an ETF’s authorised participant – the key player in an ETF’s creation-redemption mechanism – can act as a buffer between the ETF market and the underlying illiquid asset in the case of a market sell-off.
It argued the delayed NAV response to price movements – an implication of frictional baskets – means the ETF would not immediately transmit the selling pressure to the underlying illiquid asset in times of fire sales.
In other words, the ETF would absorb the panic selling in more liquid markets, making them effective in preventing rapid liquidation of illiquid assets in a market sell-off.
McGivern stressed the role of the secondary market cannot be understated: “I would highlight the difference in volumes between trading on the primary and secondary markets. Even on what are extensively illiquid underlying products, you’ll find the secondary market is doing the vast majority of trading.
“It is roughly around five to one in terms of secondary versus primary in areas like high yield.”
Can snowballing ETF assets cause a market avalanche?
Denoiseux pointed to the high-yield bond market in highlighting the secondary market’s success in providing liquidity for investors, but he is much more cautious on its ability to do so in even more niche areas of the market.
“In the case of a well-diversified investor base, then yes, it might be beneficial,” he said. “But it is actually quite hard. It takes time for the secondary market to be set up and to have enough counterparts – be that hedge funds, insurance companies, pension funds and retail investors with a broad risk appetite and investment horizon. It is hard to guarantee if investors will be there or not.”
Illiquid opportunities
Away from the well-documented high-yield bond space, another area to be explored is the leverage loan space, an area that captures the interest of DWS’ Souliac, but that is not possible due to Europe UCITS regulations.
He said: “Certain loan markets, we would love to provide access to via ETFs. There is a good level of liquidity, especially in the US with leveraged loans for example, but this has been so far impossible for us to bring into an ETF because of UCITS regulations requiring debt instruments to be de-facto clearable securities.”
Bank loan ETFs are composed of loans made by banks to other corporations, and since the credit quality of these loans varies considerably, they can be viewed as risky investments.
This has not stopped the US leveraged loan market from growing to over $1.2trn at the end of 2020.
Leading ETFs in the space include the $7.7bn SPDR Blackstone Senior Loan ETF (SRLN), the $6.6bn Invesco Senior Loan ETF (BKLN) and the $2.7bn First Trust Senior Loan Fund (FTSL), each of which has recorded modest returns over the past 12 months at 7.6%, 4.8% and 6.7%, respectively.
Since 2020, UCITS funds have been forbidden from investing in the loans, as they qualify neither as market instruments nor as transferable securities.
Elsewhere, Kenneth Lamont, senior analyst, passive strategies at Morningstar, said another asset class that could be explored is private equity. While not being able to track hedge funds directly, there is a way it can be mimicked by ETFs, as done so by the $1.1bn iShares Listed Private Equity UCITS ETF (IPRV).
IPRV tracks the S&P Listed Private Equity index, made up of 71 companies, with Brookfield Asset Management (7.7%), Blackstone (7.2%) and 3I Global (6.3%) all appearing in the top 10 holdings, returning 59.7% over the past 12 months.
Despite remaining on the lookout for liquidity premium, Souliac said DWS has probably been more cautious than others, and is reluctant to take on higher liquidity risk in the hunt for yield, a sentiment he explained is driven by his clients.
“We are a little bit reluctant to provide access to securities with an even higher liquidity risk just for the sake of fitting the bill in terms of yield,” he said. “There is a lot of discipline from our clients. I feel some clients will continue to want extra yield, but some will remain in core fixed income.”
This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
