The Big Risk Lurking in ETF Markets

Credit ratings agency Moody’s has issued a warning about liquidity in the $3.4 trillion ETF market.

Michael Nagle/Bloomberg

Michael Nagle/Bloomberg

The markets underpinning credit exchange-traded funds are showing signs of declining liquidity — and that could spell trouble in the next downturn, new research from Moody’s Investor Service argues.

“Unexpected market liquidity shortfalls could be most pronounced within ETFs tracking inherently illiquid markets, such as high-yield credit,” stated the report, published Thursday. “These ETF-specific risks, when coupled with an exogenous systemwide shock, could in turn amplify systemic risk.”

The $3.4 trillion ETF market has grown rapidly during a period of “relative calm,” meaning it has yet to be tested by a period of high market distress or volatility, the research showed. But the funds sometimes invest in instruments that become hard to sell in times of market stress.

ETF market makers— and authorized participants looking for arbitrage opportunities — trade dynamically to balance the supply and demand for ETF shares and their underlying assets, the report said. But if liquidity in underlying markets suddenly dried up, market makers would likely price that risk into their ETF quotes.

“In effect, ETFs track not only the performance of their underlying assets, but also the liquidity of these assets,” the report said. “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.”


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In other words, investors may be in for a nasty surprise if and when their ETF’s liquidity profile starts to mirror that of its underlying assets, particularly in the less liquid fixed income markets.

“By design, the ETFs are designed to mimic the performance of the underlying asset,” said Fadi Abdel Massih, the report’s author, by phone Thursday.

Because of this, he said, they would also mimic the underlying asset’s liquidity.

“We think that what’s likely to happen when there’s a dislocation between the liquidity in the primary market, when the market makers are locating the bonds that are available to balance the price of the ETF with the net asset value,” Massih said. “The tougher it is to find these products in the primary market, that would be reflected in wider spreads in the ETF itself.”

He added that this scenario is likely to happen when there’s more volatility in the market.

At the same time, ETF market structure has evolved.

“We’re looking at a changing environment where the traditional banks that acted as market makers have stepped away from the scene,” Massih said. Moody’s said it expects more technologically advanced, non-bank proprietary trading firms to play an increasingly dominant role as liquidity providers in ETF market-making.

While liquidity in credit markets is expected to improve as the process becomes more electronic, that process is still in its early stages, the report showed.