Warning For Credit ETFs: Liquidity May Be Threatened By Underlying Asset Liquidity

Exchange-traded funds are generally seen as simple investment vehicles because they are passive in nature. They track their underlying index or assets, but the way they do so is far from simple. Although the ETF markets have enjoyed a calm period of tremendous growth over the last 10 years, they could experience their first round of extended volatility in the near future.

Equity and credit ETFs have grown fast

In a note last week, Moody’s analyst Fadi Abdel Massih and team note that it requires a wide array of participants to provide and maintain liquidity in the ETF market. “Market-makers and Authorized Participants” seek arbitrage opportunities by balancing the supply and demand of shares in ETFs and their underlying assets, “helping minimize tracking errors.”

However, they note that the ETF markets haven't yet been tested by a "prolonged period of market distress or high volatility." They have grown almost six-fold over the last 10 years, which have been relatively calm. The one dip observed in 2018 occurred during the fourth quarter.

credit etfs

Both equity and credit ETFs have grown rapidly, and although the equity ETF market is still much bigger, fixed income ETFs have been following a similar growth trajectory. Moody's estimates that about two-thirds of fixed income ETFs track corporate debt. The firm pegs this segment of the market at approximately $420 billion, an increase from $50 billion a decade ago.

credit etfs

Unfortunately, the Moody's team adds that the underlying assets of the credit ETFs, mostly corporate debt and issuances, are showing signs of declining liquidity, which could pose a problem for the ETFs that track them.

Experimentation and disruption

Over the last decade, the structure of the ETF market and its participants have changed quite a bit, they add. The Moody's team notes that today most ETF market-makers are "less regulated, technologically advanced trading firms."

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This article first appeared on ValueWalk ...

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