Howard Marks Sounds The Alarm On ETFs And Passive Investing, Again

Wednesday, July 26, 2017
By Paul Martin

by Tyler Durden
Jul 26, 2017

Back in March 2015, Howard Marks was among the first to sound the alarm on the encroaching danger posed by both ETFs in particular, and passive investing in general, when he memorably asked (rhetorically, for now), “what would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once?” and answered his own question:

“in theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.”

Not to make a too fine a point of it, Marks underscored just how profound the role of liquidity can be at a time when everyone needs it, and none is available:

In September 2008, AIG experienced serious liquidity issues (despite its $1 trillion balance sheet) when it couldn’t post $20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in as a result, lending support that eventually reached $182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound.

In the ensuing two years, while the ETF market has only gotten more “liquid” (at least in a time when liquidity wasn’t actually needed), the underlying bond market has seen bid/ask spreads widen as liquidity in single-name securities has shrunk. This has not been a purely credit-linked concern, as increasingly more ETF-linked “events” have emerged in other asset classes, including the most liquid one: equities.

Fast forward to today, when the Oaktree co-chairman, in his latest memo titled “There They Go Again… Again” has not only shared his broader thoughts on markets and the current investing environment, as follows…

The Rest…HERE

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