Icahn/Fink Argument Over Bond ETFs Highlights Deep Debate Over Market Liquidity

Jul 17 2015 | 2:02pm ET

The confrontation between famed investors Carl Icahn and Blackrock’s Larry Fink over bond ETFs earlier this week at an industry conference highlights the growing concern that such instruments may be far riskier than their proponents have led investors to believe. 

Opponents of the instruments, or at least the outsized popularity of them, argue that they provide a warped impression of underlying liquidity, since bond ETFs, particulary high-yield ones, often hold highly illiquid instruments. In a market crisis, those bonds could become very difficult to sell precisely at a time when investors are relying on deep liquidity to exit positions.

ETFs have been among the most popular financial product innovations in modern times, promising easy and relatively cheap access to a dizzying array of specific investment niches.

Investors can buy baskets of securities targeting sectors, nations, currencies, instruments, physical commodities and, increasing, alternative investment strategies using ETFs, which are publicly traded and available through regular retail brokerage  accounts.

However, when it comes to fixed-income ETFs that focus on bonds, opinions sharply differ. Some, like Icahn, believe the structures lend a false sense of security when it comes to liquidity, and warn that a washout of monumental proportions is looming if a bond market selloff sends hoardes of ETF investors to the exits at the same time.

This is because the underlying bonds held by many ETFs are not liquid themselves, and would be severely punished in a sharp selloff. The NAV’s of the ETFs would be decimated, despite their veneer of stock-like trading liquidity.

Icahn has been particularly critical about the prevalence and popularity of high-yield bond ETFs, which he believes are part of a general high-yield bubble partly fueled through a combination of a worldwide hunt for decent yield and the marketing prowess of companies like Blackrock. As investment-grade yields rise, high-yield bond ETFs could be particularly vulnerable as investor demand for the riskier bonds underlying them dries up.

Managers could be put in tough spot under such a scenario. Individual investors are not known for their strong stomachs when it comes to bond market downturns, and a headlong rush out of bond ETFs that hold loads of thinly traded bonds would force their managers to sell holdings at any price, exacerbating the selling pressure and setting off a chain reaction.

The end result is a bond ETF market that appears to individual investors as safer and more liquid than it really is, opponents note. Icahn even went to so far as to characterize Blackrock as a “dangerous” company during the session, and accused it of acting in a similar manner as Wall Street banks did in 2007 when they knowingly sold billions of dollars worth of subprime mortgage-backed securities to a public that perceived them to be safer than they really were. 

Fink, for his part, defended Blackrock’s huge ETF business as beneficial, noting that ETFs actually aid in liquidity and price discovery of those same illiquid assets that worry Icahn. He suggested Icahn didn't really understand how ETFs work, a questionable assertion given Icahn's background.

Fink also argued that higher interest rates would likely result in more capital flowing to bond markets, not less. Instruments like ETFs deliver greater price transparency to the bond markets than anything that has come before, especially in high-yield, he noted. 

The sparring is indicative of a general debate that has accompanied the rise of ETFs, particulary liquid alternative ones that seek to mimic the sophisticated strategies often employed by hedge funds. The argument centers primarily around whether investors have a broad misconception that ETF portfolios are as liquid as the ETFs themselves.

The rise of liquid alts has helped fuel this debate. Although notionally aware that an hedge fund replication ETF may trade in complicated swaps and other derivatives, for instance, individual investors are generally surprised to learn that such instruments often trade OTC, and can thus carry very significant liquidity risk in times of severe market pressure. 

Blackrock bought the iShares family of ETFs from Barclays Global Investors in 2009. The company’s 700 funds manage more than $1 trillion in assets and own 40% of the U.S. ETF industry’s $2.1 trillion in assets.


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