ETF’s “Gate” liquidity

Did fixed income ETF’s sing their swan song yesterday?  Maybe not, but after the abysmal performance yesterday, investors must reevaluate the risk and liquidity of an ETF before assuming the product is a cost-effective proxy for a diversified fixed income portfolio.  In the midst of the fixed income rout, ETF sponsors found themselves unable to absorb the selling.  The Financial Times quotes a Citi e-mail in which the trader wrote, “We are unable to take any more redemptions today…due to capital requirements we are maxed out.”  In the same article the global head of ETF capital markets at State Street was said to contact participants “to say that we were not going to do any cash redemptions today.”  While the fixed income market has been volatile over the last two days, it was not in a state of panic, and yet a number of ETF sponsor effectively “gated” redemptions.  Attached below is an excerpt from our January 2013 monthly write-up describing the risk inherent in the ETF market, and a link the Financial Times article.  Please don’t hesitate to call if you have any questions.


“As we’ve discuss on several occasions, the structure of an ETF has the potential to destailize markets should investors rush to sell.  One way to measure market liquidity is to divide the market capitalization by average daily volume, which yields the average number of days to turn over the index.  A lower turnover rate is indicative of a more liquid market.  The two largest high yield exchange-traded-funds manage a combined $27 Billion in assets, representing 468 million shares.  The daily volume for the two total 9 million shares, or 1.9% of total shares outstanding.  By comparison, 7.5% of the market capital of the S&P 500 changes hands on a daily basis.  Based on those statistics, the S&P turns over every 13.3 days, while the two largest high yield funds turn over every 52 days.  To further the point, the constituents in the S&P 500 are widely followed, actively traded companies.  The same can’t be said of a number of bonds in the high yield ETF.  The conclusion as we see it is that should an event “spook” investors, the rush for the exit is likely to worsen the selloff.”