Over the last several weeks, two years after Howard Marks first brought attention to the topic with a letter in which he asked “What Would Happen If ETF Holders Sold All At Once?” some investors have once again quietly voiced concern about the inordinate and rising influence passive investing in general, and ETFs in particular, exert on stocks but especially on fixed income securities, including illiquid bonds and loans. To address some of these concerns, earlier last week, Goldman Sachs released a report titled “A closer look at years of passive (aggressive) investing in credit” in which it observed that the growth patterns shown in Exhibits 1 to 3, particularly the increase in the ownership share of ETFs have consistently raised concerns among fixed income investors and regulators.
The fear is that the combined effect of the “liquidity mismatch” inherent to ETFs and a potential abrupt reversal of the inflows of the past several years could prove damaging to the secondary market. In February 2013, then Fed Governor Jeremy Stein echoed these concerns, pointing specifically to the growth of corporate bond ETFs: “If investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt.”
Stein’s concern was proven to be warranted two years later, in August 2015 when a wholesale “glitch” in ETF liquidity caused the infamous flash crash which led to a partial market shutdown, and the VIX going offline for over half an hour.
Another frequently encountered narrative, Goldman notes, is that ETF inflows, the process through which new shares are created, exert decent technical pressure on secondary market prices and liquidity.
Goldman’s conclusion was that while concerns are indeed growing, especially in the area of junk bonds, where there has been a pickup in flow volatility in recent months, for now there is no indication that ETF clustering could result in the kind of dramatic firesales witnessed by the market in the summer of 2015.
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