-- SOURCE: 09-25-17 MarketViews - "The ETF Vortex" --

 On the surface, ETFs are one of the most sensible investment choices that an investor can make, aren’t they? In an era in which active managers have been serial under-performers, surely ETFs which track the chosen index almost perfectly and charge significantly lower fees than their active cousins, are a very sensible investment choice. We have no argument in this particular part of the ETF debate.

Where we think the debate gets interesting is from a macro perspective. When an investor decides to invest into an ETF, there is no value or price analysis on the underlying index components. Yes, there may be a decision about whether the underlying index (country, sector, asset, whatever) is an attractive investment. But there is no comprehensive analysis on all the index components, and all too often, there is very little or no thought about the price either. Simply put, capital is at risk of being misallocated, and considering the industrial use of ETFs, we are pretty much convinced that this is the case.

Now, we don’t consider ourselves to be experts on the ETF industry. We do use ETFs, for example when we want to get exposure to Gold or certain equity indices; as noted above, we think this is a perfectly sensible choice to make in individual circumstances. From a macro perspective, we have tried to consider the impact that ETF investing is having on financial markets. However, for those that wish to increase their understanding, we suggest they watch a series of videos on Real Vision TV. In the words of Grant Williams, what you will learn from these videos will simply blow your mind.

Real Vision interviewed Steve Bregman of Horizon Kinetics, and we can only surmise that he is probably one of a handful of people who have truly researched, considered and opined about the intricacies of the ETF industry (both the positive and negative aspects), how this is leading to a misallocation of capital, and has created an historic bubble in most corners of the financial markets. We will only consider one of the examples he touched upon in his interview, but we encourage everyone to watch these videos; they contain some extremely important information for all investors, whether you use ETFs or not.

IShares manage an Emerging Market High Yield Bond ETF and this has been a pretty successful and popular ETF. The year to date return is +8.80% in US Dollars and the assets in the fund have increased from about US$100 million to over US$550 million (some performance and approximately $400 million of inflows). So on the surface, both investors and the ETF manager (who charges a fee of 0.5% to manage the ETF) are winners. What’s to grumble about?

Chart 1 – IShares Emerging Market High Yield ETF; share price and shares outstanding last 12 months

The top holding in the iShares ETF is a US Dollar denominated bond issued by The Russian Federation with a coupon of 7 ½% maturing in March 2030 (please watch the video to see what other holdings the fund has – it will blow your mind). The Russian Federation is rated BB+ by S&P and Ba1 by Moody’s. For reference, we found the following definition of S&P ratings.

“Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are regarded as having significant speculative characteristics. ‘BB’ indicates the least degree of speculation and ‘C’ the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposure to adverse conditions.”

So, it would seem that the Russian Federation has speculative characteristics and exposure to adverse conditions, but that may not matter if the yield premium over the risk free rate is sufficiently large to compensate, AND you expect to get both your capital back and your annual coupons. The question investors need to ask themselves is what premium they require over and above the risk free rate (let’s use the 10 year US bond yield) for them to buy and hold this bond. Perhaps a useful starting point would be to compare this bond with other similar bonds. For a short cut, let’s look at the extra yield of US Dollar denominated Emerging market Sovereign bonds as measured by JP Morgan. As can be seen in the chart below, the current premium is 320 basis points.

Chart 2 – JP Morgan Emerging Market Bond Index Spread over US Treasuries

Well, incredibly, the current yield premium for the Russian bond is 30 basis points, and for quite a number of days this year, the yield has actually been less that the US 10 year Treasury Note. This is simply insane, and is one of the best examples we can find (with only a cursory look we have to admit) of how capital is being misallocated in recent months/years.

Chart 3 – Yields on Russia 7 ½% 2030 and US 10 year Generic Bond

How on earth can this particular bond trade for many days with a yield less than an equivalent US Treasury bond? Surely, a rational market place would bring in arbitrageurs that would short this bond, either against the equivalent Treasury, or perhaps against an equivalent Sovereign bond where the yield is more in line with say the JP Morgan Index. Surely, they would short it until the yield approached some sort of relative fair value? In any case, an active manager would be questioned by both colleagues and investors if he was buying and holding this bond.

As we can see from chart 1 above, that particular ETF has received approximately $400 million of new money this year. This, however, rather pales in comparison to another iShares Emerging Market Bond ETF traded in London with the ticker IEMB which currently has over $8 billion of assets; up from less than $4 billion a year ago. This ETF also holds the same Russia bond as its top holding. So, if we assume that the Russia bond has a similar index weighting today as it had at the beginning of the year, then just these two iShares ETFs will have had to buy approximately $50 million worth of the Russia bond.

The likely buying across all iShares ETFs is likely higher, and across all ETF providers higher still. This constant flow of money into (in this case) Emerging Market Bond ETFs creates a constant buy order for particular bonds, regardless of whether these bonds offer fundamental value and regardless of price. And it is this constant buying in what is still a rather illiquid security that pushes the price up past fundamental value.

If we (and Mr Bregman) are correct that ETFs are creating a misallocation of capital, then perhaps we should be asking ourselves a) how long this can continue, b) how will it end and c) is there an investment opportunity from a macro perspective. To try and answer these questions in short hand; a) probably longer than we care to admit, b) badly, perhaps very badly and c) yes, at some point, shorting the assets that have risen in value the most due to massive misallocation of capital will probably be very lucrative, but being short as they continue to rise can be costly.

We have speculated before that perhaps the flow of money into ETFs will slow as the baby Boomer cohort begin to retire in greater numbers and begin to either cash in their retirement funds and/or reduce risk in them. To date, this has not happened. To paraphrase Mr Bregman, this is just one huge yield induced bubble. We also worry that as central banks begin to unwind their extreme crisis policies, the bubble is at risk, and that there are any number of traders/investors who will begin to sell if they think momentum is rolling over.

We have also tried to make the case, as did Mr Bregman that market liquidity is a factor that most investors underestimate today. Again, to paraphrase Mr Bregman, there is always an offer when someone wants to buy. It may not be an attractive offer, but there will be an offer; and furthermore, ETF providers don’t care about whether the offer is attractive, they simply have to buy to meet their mandate, thereby pushing price higher, especially in some of the less liquid securities.

The trouble comes when someone wants to sell, as there may be no bid…literally no bid! We have seen a couple of scary episodes in recent years when markets temporarily panicked, and bids evaporated, even if only for a matter of minutes for most active securities. We can debate whether these episodes will be repeated, and if so, will they be worse than previously or not. But the point is that trying to sell anything if markets become illiquid is simply not possible.

Frankly, we think it is only a matter of time until we endure another ETF Vortex moment, and there is a decent chance that with Central Banks now withdrawing their monetary support, this will be the worst one yet. The trouble is (and as an increasing number of active managers are becoming all too painfully aware of), the longer it takes for this moment to come, the longer the misallocation of capital will be rewarded. This is a subject we fully intend to cover in more detail in the future. In the meantime, we along with Mr Bregman, will be very attentive to exactly what it is we are buying or trading in.