Ok, dammit.

One of the things that’s been bugging the hell out of me for at least two years is the prospect of active mutual funds using HY ETFs as a liquidity sleeve or, more to the point, as what amounts to a cash substitute.

Basically, they’re managing flows with ETFs in order to avoid the cash market for the underlying bonds. That may not sound inherently nefarious (and maybe it’s not), but it is damn sure some semblance of incestuous. Because it’s obvious what they’re doing, right?

I mean if you’re a high yield mutual fund and you’re holding HY ETFs then what you’re trying to do is have your cake and eat it too. You can stay fully invested via the ETFs but claim to have a cash buffer because after all, the ETFs are liquid. Obviously, that’s bullshit. Those ETFs are not cash. You can mitigate flows with them (i.e. dodge the cash market for the underlying bonds by selling portfolio products instead), but in the final analysis, that’s a shell game.

Back in 2015, Reuters reported that some ETF issuers were increasing credit lines in order to ensure they could manage outflows without inadvertently triggering a fire sale in the HY market. Part of the problem here is that in the post-crisis regulatory regime, banks are less willing to lend their balance sheet in a pinch, and so with the middleman thus hamstrung by regulatory reform, some of these fixed income products need to figure out what they’re going to do in the event a wave of outflows comes calling.

I’m not going to dive back into this debate too deeply here, but the bottom line is (and has always been) precisely what Howard Marks said in 2015. Namely that no matter what anyone tells you, the ETF cannot be more liquid than the underlying and in a pinch the ETF will be precisely as liquid as the underlying assets and no more. Period. It’s great (I guess), that we’ve developed a mechanism that effectively transforms relatively illiquid bonds into ETFs with daily liquidity and yes, that mechanism does seem to be getting more efficient over time (i.e. the NAV basis has been well-behaved), but in a fire sale scenario, it won’t work. Especially not when dealers are reluctant.