In the report, Moody’s said market makers, during periods of liquidity drought, would reflect this in their quotes, meaning ETFs have the added risk of tracking the liquidity of their underlying assets, as well as the performance.
Furthermore, the report added market makers, as businesses, are exposed to market, liquidity and operational risks, which could heighten systemic risk under periods of market stress.
Fabi Abdel Massih, assistant vice president analyst at Moody’s and author of the report, commented: “ETFs targeting illiquid instruments, such as corporate bonds, would present greater risks, and investors trading on the premise that ETFs are more liquid than their baskets may find that results fall short of expectations in a stressed environment.”
However, commentators have highlighted a number of reasons why investors should not be as concerned about the ETF structure as Moody’s is suggesting.
Firstly, it is crucial to remember that ETFs simply track the underlying asset class so if the dynamics of the asset class change then this would translate through to the ETF.
As Henry Cobbe, head of research at Elston Consulting, says, “ETF liquidity is only ever as good as the underlying asset,” meaning spreads will widen substantially if the underlying liquidity dries up. This is no different from traditional mutual funds or individual securities.
What is different, however, Cobbe stressed, is there is a secondary market for ETFs, where, in the event of a discount to the NAV, a clearing price can be established between buyers and sellers.
“We have seen this happen in the equity space when ETFs have continued to trade despite a stock market being closed,” he continued. “In the bond market, ETFs have been tested in stressed conditions and so far, have proven resilient.”
James McManus, head of ETF research at Nutmeg, added: “There is nothing revelationary [in the report]. Broad index exposures are often easier and cheaper to hedge than individual securities, so there is some room for ETFs to have liquidity dynamics that are different to the underlying securities as liquidity providers warehouse the risk.”
An issue highlighted by Jim Goldie, head of ETF capital markets, EMEA, at Invesco, is ETFs still represent a relatively small proportion of overall assets. For example, high yield ETFs account for just 2.5-3% of their respective underlying markets.
Therefore, Goldie said the ETF flows are too small to have a consistently meaningful impact on bond pricing and be the main cause of systemic risk in an asset class.
He referenced a report by analysts at Citi, which found: “While ETF assets under management are non-trivial, ETF flows are still too small to influence bond pricing.”
Goldie added: “The structure of the ETF allows clients to use ETFs as a price discovery vehicle, especially in segments of the market that can be less liquid by nature, such as fixed income. In the credit space, there is no exchange venue for the individual bonds and in very broad benchmarks there may be a number of bonds that do not trade on a daily basis.
“The ability to create and redeem ETF shares for a liquid basket of bonds that is a subset of the overall benchmark, and still manage to match the overall credit quality, sector and duration profile of the index, allows liquidity providers to access the primary market in order to facilitate ETF trading with minimal impact for the client.”
Another area of potential risk highlighted by Moody’s was the majority of ETF market making is being handled by less regulated, technologically advanced trading firms and less so by banks.
Despite the increase in flows, however, Goldie said it is still the same group of investment banks, brokers and market makers that are active in pricing and trading ETFs.
“Banks’ trading businesses have adapted and improved from a technological perspective in order to remain competitive in pricing ETFs across asset classes.
“The increasing levels of price competition and transparency has been a net positive for end clients,” he concluded.