One of my college friends served as the general counsel of a major mutual fund company. When we talk about our respective businesses and business models he often comments on how lucky PE managers are because they do not promise daily “liquidity” to their LPs. By contrast, the biggest fear among mutual fund managers is providing liquidity. That fear has been calmed by massive inflows of liquidity from accommodative central bank fiscal policies for most of this century. Much of that liquidity has also ended up in the U.S. stock market and its two favorite products, mutual funds and exchange traded funds.
In response to high functioning, highly liquid markets the financial services industry is doubling down on “collective” products like mutual funds and exchange traded funds where millions of owners concentrate their investments in specific sectors through mega funds. This proliferation of products has led to sector funds and ETFs for every conceivable asset class, even those with wild price swings or thin trading markets like high yield funds or Russian assets. While the liquidity risk is different with these different products, they both rely on smooth functioning of the capital markets.
For mutual funds they derive their liquidity to meet redemptions from sales of underlying securities. So when you redeem shares of Fidelity’s Magellan Fund you are promised the net asset value at the close of business on the day your order is posted. Fidelity then has to find the cash to pay your redemption amount. If they have an orderly market, the redemption price can be achieved. In a disorderly market Fidelity might struggle to fill your order at the daily close NAV.
ETFs are different. They actually trade shares in the market like a common stock but the securities within their index portfolio do not trade. Volatility in the trading markets can create a large disconnect between the price at which you can sell your ETF shares and the value of the underlying portfolio comprising the index. This is what happened at the end of August 2015 when there were precipitous drops in the trading prices of many sector ETFs at the market open. There was not good visibility into the trading values of the underlying portfolios; many ETFs disconnected liquidity price and value.
In response there were articles in Forbes and The Wall Street Journal exonerating the ETF asset class and blaming computer glitches for mishandling the rush of “market orders” at the open, and for distorting and obscuring value such that panic pricing (liquidity at any price) replaced an orderly market. Barron’s reporter, Chris Dietrich, presents a more balanced view in an article published September 5, 2015 entitled “The Great ETF Debacle Explained” where he explains circuit breaker rules adopted in 2010 obstructed the normal trading pattern by putting arbitrageurs on the sidelines. As a consequence there was no counter party to buy ETFs when a perceived gap between their trading price and portfolio valuation appeared. Mr. Dietrich explains as follows:
“Typically, whenever an ETF’s share price falls below—even by a few cents—the sum total of the price of its assets, authorized participants will essentially buy huge swaths of the discounted ETF shares and exchange them for a basket of the actual holdings, which it then sells at a profit. This arbitrage process is what keeps ETF prices in line with their holdings—the slightest discrepancy triggers institutional arbitrage that then eliminates the discrepancy. But when trading was halted in both the stocks and ETFs, this arbitrage couldn’t occur.”
A $2 Trillion Asset Class Victimized By Dodd Frank
ETFs comprise a $2 trillion asset class and constitute more than 40% of the trading volume of the U.S. equity markets. It is remarkable to me that the SEC has strictly regulated the equity capital markets by imposing circuit breakers to prevent market meltdowns from computer and panic trading without having any idea how that regulation will affect its most popular products like ETFs. I do not believe that the August problem with ETFs was an isolated computer glitch. Rather, it reflects the inherent volatility of capital markets when checks and balances motivated by arbitrage profit are suspended by regulatory intervention. Dodd Frank strikes again!
It is in periods of time like August of 2015 that I am happy to be representing an asset class that does not promise liquidity and where the most current legal valuation of the underlying portfolio is often 6-12 months old. The Private Equity Asset Class has always carried a much higher risk premium that ETFs and mutual funds. If I am right and we are going to experience heightened public market volatility, the risk premium may shift to publicly traded products as daily liquidity is challenged and public markets valuation concepts are reexamined.
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