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Michael Lipper warns of liquidity crisis in ETFs

Michael Lipper warns of liquidity crisis in ETFs

The current editions of one of my favorite magazines, Barron’s has a cover story entitled "Income: The Best ETFs for Yield.” I have no problem using a collective vehicle as a way to invest in fixed income.

This is becoming very popular. According to my old firm, iBoxx $ 1 G Corp Bond ETF had the highest net inflows of the week of all ETFs, totaling $412 million. My concerns are first that the ETF trades many times a day, some of the underlying bonds trade rarely.

While the popular press thinks most of the flows around ETFs is from individual investors, I suspect most of the trading is done by institutional investors, often hedge funds and other professional traders. Often these trades are done in combination with other trades combining long and short positions.

This is a cheaper way to do these trades than through their prior habit of using futures. Except in the special case of Vanguard who has been able to create an ETF class in their low cost open end funds, most of the other funds can't absorb a large amount internally, they will have to find a buyer for the ETF's selling specific bonds.

In addition, most ETF transactions pass through "Authorized Participants" who act as did the old specialists did on the floor of the stock exchanges. There are often a small number of "APs" for each ETF. These dealers often make markets in other securities as well.

The old specialists used to have known levels of capital which was closely supervised by the various exchanges. These artefacts don't seem to be in place in today's world.

My concern is that at some unknown point in the future the major hedge funds and other traders will feel compelled to quickly liquidate their fixed income and perhaps other thinly traded security ETFs.

Some of the thinly capitalized ETFs cannot absorb the sudden waves of selling at the same time the sponsors of the ETFs cannot absorb the continuous waves of selling.

It is important to declare this has not happened....yet. But it did to the old single stock specialists on the floor of the exchange. My concern, just like various economic laws and constants not working, there could be a liquidity crisis in the ETF world.

My suggestion is that wise investors assign some chance of this event and monitor the relevant conditions.

A former president of the New York Society for Security Analysts, he was president of Lipper Analytical Services Inc. the home of the global array of Lipper indexes, averages and performance analyses for mutual funds. His blog can be found here.

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