The low level of liquidity in fixed income markets makes ETFs vulnerable says Louis Gargour, managing partner and CIO of LNG Capital. “I think it’s a very unappreciated big financial risk,” he says, citing data that reveals proprietary trading capital in high yield in the US is now USD50 billion out of a market that’s worth just over USD4 trillion.
“Back in 2008, proprietary trading capital in high yield in the US was USD500 billion out of a USD2.2 trillion market,” Gargour says. “Banks now have little proprietary capital assigned to risk assets.”
Gargour’s argument is that high yield ETFs are vulnerable to being on the sharp end of a reduction in liquidity in the sector at bank level. “Who does an ETF sell to, now that the underlying liquidity of a normal market is much lower since the banks are no longer involved as principals in trading?” he asks.
Gargour points out that a lot of a bank’s activities nowadays, post all the post financial crisis new regulatory regime, is to act as an intermediary, finding a buyer, rather than being the buyer. He estimates that intermediary activities take up 85 to 90 per cent of what banks are doing now they cannot, as he puts it: “Stand up and say, ‘this is value here’ and buy it.”
Within Europe, the ECB holds a huge proportion of outstanding corporate bonds, due to their bond buy-back programme, with Gargour commenting that 40 per cent of investment grade bonds, in the auto sector for instance, are bought up by the ECB . “As a result of ECB bond buying, the liquidity, the free float, is significantly smaller than the issue size would have you think,” Gargour says.
“The underlying liquidity as a result is low, therefore if there is a shift in investor sentiment, the sales must be intermediated by the banks to an end buyer which is a buy side institution. If there is a negative news story driving prices lower, there are limited numbers of potential buyers. ETFs will be therefore forced to be indiscriminate sellers at any price.”
ETFs, he says, flatten the yield and squeeze it lower so that all the sectors and names are indiscriminately converged to the same yield, regardless of the underlying differences in the companies.
Gargour comments that high yield has a high demand from retail investors who are looking for income. Within his Europe Credit Fund, a USD280 million actively managed fixed income fund focused on European corporate debt, Gargour believes that value lies in smaller sub-USD1 billion issues where the ETFs and large fund houses have not done any research, and where deep dive intelligent analysis can produce a competitive advantage.
“A number of the issuers in a portfolio have yields significantly in excess of the larger issues and ETFs simply because they are mid-sized companies and the ETFs cannot purchase them due to their size.” LNG capital has identified a number of these midsize companies with very attractive yields ranging between 8-12 per cent for solid companies.”
The Europe Credit Fund has achieved an annualised return since 2011 of 12.95 per cent placing it in the top decile of fixed income hedge fund performance tables. Gargour was formerly head of fixed income at USD7 billion hedge fund firm RAB Capital, which gives him a track record with this strategy back to 2001. In 2006 he set up LNG and launched it as a family office with colleagues from his former firm. His background also includes senior roles at Goldman Sachs, J.P. Morgan, and Salomon Brothers.
The strategy was managed within a managed account until 2011 when it was converted to a long/short fund due to strong client demand for a fund structure. This opened the strategy to a wider investment audience. He uses ETFs, “to short the heck out of the market” to quote him. “If the market goes down then the ETFs go down as a market proxy with the added benefit that ETFs will in certain circumstances overshoot the market on the downside,” Gargour says.
He predicts that when everyone has same idea at the same time and outflows start to happen, ETFs will either gate themselves or have the bid price gap significantly lower in order to reflect the mismatch between liquidity and cash demanded by redeeming clients.
He doesn’t think ETFs have a malign influence on the market but that they are too big for underlying liquidity of the asset classes they are in. “ETFs can’t not sell as quickly as potential client demand for money if there’s a shift in investor sentiment,” he says.
