One More Way ETFs Are Distorting Markets

If you follow trends in markets, you probably already knew (or at least surmised) that HY ETFs are having observable effects on the junk bond market.

It’s not entirely clear that’s a good thing. As we’ve gone to great pains to explain, an ETF can’t be more liquid than the underlying assets and as Howard Marks wrote with regard to junk bond ETFs, “we know the underlying can become highly illiquid.”

One important think to note about that assessment is that the more trading in the ETF replaces trading in the underlying, the more illiquid the underlying becomes. So when Vanguard says things like “99% of the trading volume [in fixed income ETFs] results in no trading in underlying securities,” that’s actually a bad thing – contrary to how they’re trying to get you think about it.

Well, in addition to everything we’ve already said about the dangers inherent in HY corporate bond ETFs, we wanted to add one more concern.

When you think about replicating a HY bond index (which is presumably what HY ETFs are doing), you’re left to wonder if maybe flows into these vehicles are distorting the market. That is, if the index is skewed towards large capital structures (which is a given), then by definition, flows into the ETFs will begin to influence returns and liquidity in some bonds but not others. Note that this probably isn’t the case for flows into active funds, right? Because the managers aren’t obligated to stick with large capital structures.

Consider that, and then consider the following from Goldman…

Via Goldman

To assess the interplay between ETF and mutual fund flows and the relative performance of large vs. small capital structures, we construct a total return “size factor” using the bond constituents of the iBoxx HY index. This size factor can be thought of as the cumulative total return on a long/short strategy involving two otherwise identical and monthly-rebalanced bond portfolios of large vs. small issuers. These bond portfolios are identical in terms of their maturity, sector, and rating compositions.

Leaving aside the details behind the construction of these portfolios, Exhibit 14 plots the cumulative total return of our size factor vs. cumulative flows into HY ETFs and mutual funds, respectively. The verdict from Exhibits 14 is that over the past two years, the relative performance of large capital structures vs. smaller ones has been co-moving with cumulative ETF inflows. Our colleagues in EM strategy have noted a similar pattern in EM equities.

In addition to having an impact the cross-section of HY bond returns, another widespread belief among market participants is that the higher volatility of ETF flows since mid-2014 coupled with the higher market share of large capital structures (again see Exhibit 4 and 13) have stimulated the turnover on bonds issued by large capital structures relative to those issued by smaller capital structures.

We investigate this hypothesis using the bond constituents of the iBoxx HY index. We bucket bonds into various quartiles based on the issuer’s capital structure size and estimate the average daily turnover, defined as the 20-day average daily volumes divided by the total outstanding, for portfolios containing the largest capital structures and smaller ones. As with the previous exercise, we control for potential compositional differences by constructing two identical portfolios in terms of sector, maturity, and rating weights.

Exhibit 15 plots the difference in the average daily turnover on these two portfolios alongside our estimates of the volatility of weekly flows. The key takeaway here is that, since mid-2014, the average daily turnover on large capital structures has notably increased relative to smaller capital structures. The increase appears to have coincided with the uptick in the ETF flow volatility. Correlation is obviously not always synonymous with causation and the increase in the turnover of bonds issued by large vs. small capital structures may reflect the wave of fallen angels that affected a few large capital structures in the Energy and Metals and Mining sectors in late 2015 and early 2016. But as Exhibit 15 shows, the turnover gap between large and small capital structures had moved higher even prior to the acceleration in HY downgrades.