Advisers and market experts have grown increasingly concerned about the ability of large bond funds to meet redemptions in recent months, and now concerns have been growing about exchange traded funds (ETFs) which invest in bonds. While private investors can only buy and sell shares from a broker, larger institutions can redeem holdings directly, as with an open-ended fund such as a unit trust or an open-ended investment company. But last month in the US, during market turbulence, Citigroup, which acts as what is known as an authorised participant, a broker for institutions, briefly suspended redemptions on some ETFs.
However, some argue that this should not be a great concern for private investors trading small numbers of shares via brokers as Citigroup allowed this type of activity to continue. And, as Citigroup is only one authorised participant acting on these products, institutional investors could have bought and sold the ETFs via other authorised participants. For this reason, providers such as iShares argue that ETFs pretty much do what they say, and if retail investors want to get out, they can.
"I do not think that this is any reason to buy actively managed funds in preference," says Adam Laird, passive investment manager at Hargreaves Lansdown. "When ETFs work well, they can actually be more liquid than the investments they follow - they often have an advantage over actively managed products. Whenever there are liquidity problems, it often hits all products across the board and there are examples in other asset classes where actively managed funds have been affected worse by liquidity issues than ETFs. If you want a passive exposure to bonds, ETFs are still an efficient way to get it."
Investors can place orders to buy and sell an open-ended bond fund throughout the day and at the end the manager is informed on the net new money or outflow. In the case of large redemptions, the manager can be faced with a difficult situation due to the time constraints to sell enough bonds to match the redemption. If not deemed feasible, it can lead to a suspension of redemptions. But ETFs are traded on exchanges, so this situation will most likely lead to a widening of bid ask spreads and thus higher transaction costs, rather than to a suspension of redemptions.
"For example, during the Japan earthquake, Japanese equity ETFs were still quoted. However, due to uncertainty in the market, counterparties were asking for a much higher risk premium, but it was still possible to enter and redeem the ETFs," says Siu Kee Chan, investment manager, multi-asset at ING Investment Management.
Costs up
Even if you can still trade your ETFs shares, if bid offer spreads rise this can be a considerable cost. The bid refers to how much you can sell your ETF shares for and the offer is the lowest point you can buy. The difference between them is the bid offer spread. Funds with wide bid offer spreads eat away more of your returns. These tend to be in esoteric and illiquid markets such as emerging markets and can cost you well over 100 basis points for funds in the most difficult markets, but in volatile markets this can increase with regard to other assets, too.
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"We only use ETFs which track more liquid markets such as UK equities," says Damien Fahy, head of research at FundExpert. "The Citigroup issue highlights what can happen in a sell-off when you combine a high frequency trading ability such as ETFs have with less liquid assets. While perhaps it was unexpected, it is not surprising and could happen again if there is a sufficient trigger."
He prefers actively managed bond funds.
"While the large bond unit trusts could also have redemption issues in a (unlikely) bond market collapse, mangers always have the option of holding their assets until maturity collecting the coupons and par value as they are not tracking an index," he adds. "Also, active managers are already positioning their funds to cope with potential redemptions by holding more liquid assets, for example, cash and gilts, and are being proactive rather than reactive."
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But Mr Chan argues that it is rather important to look at the different ways ETF providers arrange their trading process. He suggests choosing a provider working with many different authorised participants to create a price on an ETF, rather than a very restrictive ETF provider with only a limited number of authorised participants to set a price.
"The advantage of synthetic ETFs is that fewer bond-selling transactions will be required to raise the cash to fund the outflow compared to a full replication strategy," he adds. "However, the uncertain factor will be their dependency on derivatives. As we have seen before, at times of increased stress we see volatility increase, which makes pricing on derivatives implicitly more expensive."
Trading at a premium or discount to net asset value (NAV) is typically associated with investment trusts, but can also occur with ETFs, albeit in smaller proportions. "Some ETFs have gone from trading at a premium to a discount," says Peter Sleep, senior portfolio manager at Seven Investment Management. "For example, iShares £ Corporate Bond UCITS ETF (SLXX) between July and mid-November last year traded at a premium and enjoyed inflows as the price crept up. But from mid-November to the end of March, it traded at a discount as the price declined and investors sold out of the ETF, before decisively selling off in May, suffering a big discount to NAV and major outflows. A very unlucky investor might have bought at the maximum premium and sold at maximum discount and lost an additional 1.2 per cent."
However, while iShares Euro High Yield Corporate Bond UCITS ETF (IHYG) briefly traded at a discount at the height of the panic, the discount was not very pronounced. "I find this amazing given how illiquid the emerging market debt and high yield markets can be," says Mr Sleep. "It proves the point that ETFs are helping to make an illiquid market more liquid."
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