Why Passive ETFs Face Big Risks in Liquidity Crisis

Four key asset categories may be particularly vulnerable in a liquidity crisis, including passive stock ETFs, private equity, commercial mortgage-backed securities derivatives, and leveraged loans, Business Insider reports. Given that passive stock ETFs have become enormously popular among investors, both retail and institutional, for their low cost and utility in quickly creating and rebalancing diversified portfolios, the dangers lurking behind them should be of particular concern.

Regarding these ETFs, Inigo Fraser-Jenkins, head of global quantitative and European equity strategy at Sanford C. Bernstein & Co., recently warned clients, as quoted by BI: "It means that there is an increased tail risk of a sell-off in the market becoming disorderly. A sell-off is not our forecast, but were one to happen we basically do not know what will happen when thousands of investors reach for their smart phones and try to sell positions that they have in passive ETF products."

Significance for Investors

While he acknowledges that passive stock ETFs may be the most brilliant product ever developed for individual investors, Fraser-Jenkins points out that they now control nearly half of all investments in U.S. stocks alone. Thus, if the markets start to decline, and general panic spreads among ETF owners, a huge wave of selling engulfing the entire market can follow, quickly turning a modest selloff into an avalanche.

“A general retreat from active public equities to illiquid investments [in the private sector] all point to a greater fragility of liquidity in public markets. We probably need to get used to more 'flash crashes,' and also of the potential for flash crashes that spill over from one asset class to another," Inigo-Jones also said, per BI.

Worldwide, all categories of ETFs have surpassed $5 trillion in assets. Regulators across the global are increasingly concerned that a wave of selling can cause a massive failure in the market-making activities that support these investment vehicles, the Financial Times reports.

Specifically, the so-called authorized participants (APs), typically investment banks, which create and liquidate ETF units when buy and sell orders from the investing public are not in balance, are not legally obligated to perform this market-making function. As a result, regulators worry that, in a selling crisis, APs may liquidate ETF units at steep discounts, or back away entirely from performing this function.

Regarding private equity, startups are taking many years longer to reach the public equity markets through IPOs than they did before, and the public equity markets are shrinking as the result of share repurchases and mergers. Moreover, as noted above, an increasing share of publicly traded equities are now being absorbed by passive ETFs. As a result, active investment managers are increasingly turning to private equity, but these are highly illiquid investments by their very nature, and a rush to sell is bound to cause their prices to crash, Inigo-Jones observes.

In the search of higher returns in the face of historically low interest rates, investors have been turning to risky and illiquid products. Among these are corporate leveraged loans, which offer higher interest rates than investment grade debt because the borrowers are already highly indebted. Ominously, the quality of such leveraged loans has been sinking precipitously, making these investments particularly vulnerable in an economic downturn.

Complex derivatives based on bundles of corporate loans also are becoming popular as a means to earn higher yields. Some are carved out of mortgages on shaky shopping malls, retail locations, and office buildings. Meanwhile, the number of banks willing to trade these securities has shrunk since the 2008 financial crisis, meaning that it will be difficult to offload them in the next crisis.

Looking Ahead

In the 2008 financial crisis, complex and illiquid investment securities were both a leading cause and a major victim of the selloff. The next crisis is likely to be similar in this regard.