I could build a hypothetical income portfolio to show to potential clients right now that would demonstrate incredible three-year past performance along with a ridiculously high yield relative to the risk-free rate offered by Treasurys. And I could do it with ETFs and mutual funds that demonstrate a high degree of liquidity today, when all is calm and quiet and investor appetites are raging.
And a portfolio like this – with a recent history of great gains and a big, fat income stream would be really easy to sell. Everyone wants the thing that’s working today and is rewarding people right now.
Unfortunately, this is how people get blown up when liquidity suddenly begins to ebb away. To paraphrase Hemingway in talking about how he went broke, liquidity dries up slowly at first, and then all at once.
Today’s high-income ETF portfolios – constructed as they are with bank loan funds and high yield debt – may look highly liquid on paper when assessing daily trading volumes. But, as Howard Marks explains, it’s not the trading volumes of the ETFs themselves that will matter when push comes to shove, it’s the trading happening in the underlying securities that will dictate volatility and risk for ETF investors. An ETF can appear to be more liquid than its underlying holdings but this is only a temporary mirage.
If investors are forced to sell relatively illiquid bonds because of redemptions, they’ll take increasingly lower prices so long as the buyers fail to show up. In this way, the miracle of liquid ETFs trafficking in illiquid asset classes will quickly turn from dream to nightmare.
In constructing our portfolios and setting client expectations, we’ve taken this into account. I’m not sure a majority of the wealth management firms in my industry have. They are able to win business with income models and funds that are incredibly attractive given the environment we are in today. But will these models and funds hold up in whatever environment is to come?
Or are they betting things won’t change? Or worse, are they counting on the liquidity of today to give them a chance to get out when they have to sometime down the road?
Here’s Howard Marks in his latest note on liquidity comparing the bond ETFs of today with the auction rate securities of ten years ago (emphasis his):
Auction rate securities were a way to buy long-term debt securities without interest rate risk amd illiquidity. Likewise, ETFs offer a liquid way to invest in potentially illiquid markets. But these instruments rely for their desirable outcomes on the assumption that other parties will do what they “should” do. Over the course of my career I’ve seen many instances when market participants failed to do what they were supposed to do. The related financial innovations often remind me of my father’s story about the habitual gambler who finally found a sure thing: a race with only one horse. He bet all his money, but halfway around the track the horse jumped over the fence and ran away. Will ETFs prove liquid in the next crisis? And what impact will mass sales of ETFs have on the prices of underlying assets? We’ll find out.
Fortunately for investors, scrupulous advisors don’t propose a portfolio just because it’s the one that will most easily close a new client. They propose portfolios that will work well in the future, even if they have some dents and scratches in the recent past. But not every advisor is scrupulous or forward-thinking. Some pursue new business now at all costs, even if it means they’ll be forced to apologize later.
We haven’t yet seen a situation where bond ETFs were confronted with massive sell orders all at once. The assets in bond ETFs were tiny during the last financial crisis and the category has expanded exponentially in the ensuing years.
The exchange traded bond fund category has also metastasized into all different variations on the classic Treasury + investment grade corporate mix. There are exchange traded vehicles now covering nearly every category of fixed income, from floating rate debt to local-currency foreign credit.
And sure, there’s plenty of liquidity to make orderly sales whenever you’d like today. Will that still be the case tomorrow?