Activist investor Carl Icahn attacked the exchange-traded fund (ETF) industry a week before we sent this year’s ETF Guide to the printer. He called BlackRock (BLK), which owns the iShares family of ETFs, an “extremely dangerous company.” He further asserted, “They sell liquidity…There is no liquidity. That’s my point. And that’s what’s going to blow this up.”

While Icahn’s accusations made headlines, the full story does not fit nicely into a sound bite. ETFs have gotten a bit of a bad rap for being the tools of active traders and fast money. The strategies of some ETFs, however, do provide reasons for caution—as is the case for mutual funds following similar strategies.

Icahn singled out high-yield ETFs. These are funds that hold junk bonds, meaning bonds of issuers with poor credit ratings. A hunt for yield has attracted income-hungry investors to them. As long as the interest rate environment (and the economy) remains stable, these type of investments can seduce investors into overlooking their underlying risks. Bull markets are dangerous in this respect.

His concern is what happens when interest rates rise. One assumption held by some observers is that investors will flee high-yield bond ETFs. When this happens, authorized participants (“APs,” who are institutional investors) will deliver a higher-than-normal number of creation units (blocks of 50,000 shares) back to ETF providers. This process will result in the underlying bonds eventually being sold, as shares of these funds are taken off of the market. If the redemption process results in more bonds being put for sale than there are buyers for them, prices will fall. This in turn will drive down the net asset value of the ETF (the value of a fund’s underlying holdings), potentially resulting in more investors selling their ETFs, more APs redeeming creation units and so on.

If this happens on a large enough scale, liquidity problems will surface, high-yield bond prices will plunge and yields will jump. Not a desirable scenario.

None of this means ETFs are bad. High-yield mutual funds have the exact same risk. If shareholder redemptions exceed available cash, those funds will have to sell their high-yield bond holdings, creating downward pressure on junk bond prices and the value of the mutual fund shares. This could result in a similar cycle of what may occur in ETFs.

ETFs are being singled out because most are tied to indexes. As such, the managers of these funds lack the flexibility to switch to securities that are not in the index or that are not representative of the index’s components. The same issues apply to passively managed mutual funds. Active managers with objectives requiring them to target a specific asset class or group of securities have some additional flexibility, but—depending on the individual fund—potentially not enough to sidestep the problems. This may be why K.C. Nelson, the managing director at Driehaus Capital, tweeted, “And soon a journalist will notice that the biggest HY mutual funds (particularly index funds) all have ~80% overlap w/the HY bond ETFs…”

Just as ETFs are being unfairly singled out, bonds are too. A liquidity problem could occur with commodities, stocks of smaller-capitalization countries, alternative strategies, etc. Any time there is a flood of money chasing a particular strategy, there is a risk of liquidity problems if the market isn’t large enough. Long-Term Capital Management (LTCM) remains a good example. While the 1998 Russian financial crisis was the catalyst for the hedge fund’s demise, what truly brought the fund down was its inability to unwind its positions at favorable prices. There were too many other competitors mimicking LTCM’s strategy.

Finally, realize that despite all of the scary verbiage, a forthcoming liquidity crisis in junk bonds is not a certainty. Should interest rates rise gradually as opposed to spiking, the selling could be orderly, with higher junk bond yields potentially attracting new buyers.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII