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

Asset Liquidity

They add that these firms have disrupted both the primary and secondary market by "experimenting with new models for liquidity provision that continually pressure industry margins." They expect non-bank trading firms to become more and more dominant as providers of liquidity in ETF market making.

Concerns about ETF liquidity

However, they also warn that extreme or long periods of volatility may demonstrate that ETF liquidity also tracks the liquidity of the underlying market. ETF investors might have certain expectations when it comes to the liquidity of their ETF holdings. However, they should be advised that not all ETFs have the same levels of liquidity.

"A stress event could diminish the amount of standing orders at various prices and reduce the perceived liquidity of the ETF market, even when ETFs are operating as designed," they warned.

They believe ETFs tracking high-yield credit and other "inherently illiquid markets" could cause the biggest problems, especially by reducing potential rewards for market-makers.

"So, in effect, ETFs track not only the performance of their underlying assets, but also the liquidity of these assets," they explained. "Therefore ETFs targeting illiquid instruments, such as corporate bonds and leveraged loans, 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."

Equity versus credit ETFs

The Moody's team pointed out that the underlying markets for equity and credit ETFs are very different. Equity markets are deeper, while fixed income security markets "are more heterogenous and generally shallower." However, they believe that developing and increasing "electronification of credit market liquidity venues" should help make trading of credit ETFs easier and more efficient.

To demonstrate their warning, they displayed the liquidity measures of four major ETFs according to their "price dislocation from net asset value. Equity ETFs such as the SPY remain very liquidity despite volatility in the underlying index.

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This article first appeared on ValueWalk ...

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