Are ETFs as liquid as they claim to be?

ETFs’ strengths could become their weaknesses come the event of a financial crisis, according to Pau Morilla-Giner, Chief Information Officer at London & Capital.

Since the last financial crisis in 2008, ETFs have soared in popularity and now accounts for 25 per cent of all US equity trading volumes, up five per cent in the last three years. There was $1tn worth of assets invested in ETFs in 2009 which grew to $5tn by the end of October 2018, says Morilla-Giner.

The key drivers for investors transitioning to the passive investment vehicle is its low fees and liquidity. This spurs the argument that ETFs cannot be more liquid than the underlying assets. Institutional and retail investors have therefore become complacent due to this illusion, says Morilla-Giner, and is likely to backfire in the event of another crisis.

Vanguard founder, Jack Bogle, said last year, “too much money is in too few hands”. This is regarding the leading asset managers holding significant stake in the world’s largest companies. Vanguard alone owns at least five per cent stake in 491 out of the 500 companies in the S&P 500.

A couple of consequences arise from the leading asset managers dominating market share which include the too-big-to-fail problem and the true-float problem, which means the number of available shares is overestimated, according to Morilla-Giner.

The true test to ETFs’ liquidity would be the event of a major bear market. Morilla-Giner believes the commonly less-liquid field like high yield bonds would reveal ETFs’ liquidity. Morilla-Giner concludes: “Like so many new strategies deployed throughout market history, ETFs appear forever-liquid until they’re not.”

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