The stark liquidity mismatch mutual funds face during periods of market stress when offering exposure to less liquid assets highlights a crucial benefit of ETFs, the secondary market.
Investors have found out the problem of mutual funds offering daily liquidity the hard way this year. According to Fitch Ratings, over $62bn worth of global mutual funds suspended redemptions in the first six months of 2020, well above recent full-year volumes.
This includes a string of open-ended UK property funds that suspended trading after the coronavirus volatility made it difficult to value the funds. Although a number of funds have lifted the suspensions, over £5bn remains trapped.
The issue was highlighted by the Financial Conduct Authority in 2019 after star fund manager Neil Woodford was forced to suspend trading on his fund after a string of significant redemption requests.
The news even led former Bank of England governor Mark Carney to claim mutual funds were “built on a lie”.
The BoE, along with the FCA, opened a review into the £1.2trn mutual fund market to see if rules needed to be brought in. If implemented, the proposed rules will lead to longer notice periods for investors to redeem their funds, a discount mechanism when redeeming and better steps to assess the liquidity of the mutual funds’ underlying holdings.
Furthermore, the FCA has separately proposed a potential six month delay for investors looking to redeem from UK property funds.
While these steps offer some protection against suspension, it does little to address the fundamental flaw of offering illiquid assets such as property or high yield in a vehicle with daily liquidity.
As Fitch Ratings said: "We believe that the spate of suspensions and application of other extraordinary liquidity-management tools will lead investors to re-appraise the liquidity that mutual funds can provide, particularly when invested in less liquid assets."
This re-appraisal has already started to take shape with more investors turning to ETFs in the fixed income portion of their portfolios as a way of managing liquidity. According to data from Morningstar, fixed income ETFs in Europe have seen $31.5bn inflows so far this year, as at 6 October, adding to the record $63bn seen in 2019.
With ETFs offering intraday trading on many of the same underlying asset classes as mutual funds, one could be mistaken in thinking the same problems could arise. However, where the ETF wrapper comes up trumps is by virtue of trading on the secondary market.
This was highlighted by the BoE in May’s Financial Stability Report which found “the secondary market trading of ETFs means there is lower risk of a dynamic that incentivises the fire sales of their underlying assets”.
Meanwhile, the European Fund and Asset Management Association (EFAMA) has described the “overlooked” secondary market as an “additional layer of liquidity when compared to ordinary mutual funds”.
Echoing their views, Keshava Shastry, head of ETP capital markets at DWS, said that even when the primary market is suspended and authorised participants can longer create and redeem ETFs, liquidity can still be found in the secondary market.
“The ETF benefits from secondary market liquidity and the transparency of trading on open, publicly listed markets,” Shastry continued. “So even when an ETF is closed for creation-redemption – perhaps due to underlying market holidays – clients are still able to access secondary market liquidity through stock exchanges or the diversified broker network.”
The real stress test for ETFs came in March when liquidity vanished from the corporate bond market leading many ETFs to trade at record-wide discounts to their net asset values (NAVs).
What the discounts showed was a window into how fixed income ETFs provided real-time price information about their underlying holdings while the NAVs were in catch up mode.
“Even though it is painful to see your positions mark down, at least you know definitively what they are worth,” explained Daniel Izzo, CEO of GHCO, a market maker. “In periods of market stress, the reality is investors want or have to sell but if you own a mutual fund you cannot, at least not in size or in a timely way.”
Izzo went onto stress the importance of real-time pricing with ETFs as this enables investors to sell their positions at a known bid if they must.
“If you want to sell, you know the level and you can make an informed decision,” Izzo continued. “You might not like having to make that decision but having been in crisis management positions for many years, I can tell you the only thing scarier than a loss, is an unknown immeasurable loss.
“Pretending your mutual fund has not depreciated because its underlying bonds have not traded for two weeks is not only inaccurate reporting, it is a giant blind spot in the decisionmaking process for investment managers.”
What happens when the lights go out? An analysis of ETFs when liquidity vanishes
Uncertainty around valuations was the key driver in mutual fund suspensions this year, according to Fitch Ratings, compared to redemptions issues in previous years.
“We believe this will lead to greater regulatory and market scrutiny of how fund managers determine asset valuations and apply liquidity management measures,” the ratings agency added.
This article first appeared in Under The Spotlight: Fixed Income ETF Liquidity in partnership with GHCO.