ETFs have become a popular option for investors, especially for those who are looking to invest in bonds but have concerns about bond market liquidity. After all, the thinking goes, what is more liquid than something that trades on an exchange like a stock? However, the growing use of ETFs and their increasing impact on market activity have brought to light another unintended consequence of their perceived liquidity that warrants a closer look.
Typically, when funds that track indices see asset flows, they must immediately transact in the market. There is usually little leeway for managers of such funds to hold cash balances - inflows usually cause traders to lift offers in their underlying securities, while there is rarely sufficient cash to service outflows without hitting bids in the same securities. This differs from more actively-managed funds which often have discretion to be patient and look for better entry and exit points while providing some latitude on which securities to trade and how much cash to hold.
The ease with which investors can move money into and out of an asset class using ETFs has resulted in significant volatility in the total assets of these funds. This has exacerbated the frequency of “round-trip”1 trading behavior, with ETF managers sometimes lifting offers and hitting bids in the same securities multiple times over consecutive days. For bond funds, this can be costly - in choppy markets, the bid/offer spread2 that a trader pays when trading on both sides of the market can be high. We estimate a typical spread in recent months was approximately 0.50% of face value!
Each time an ETF grows and shrinks due to investors who take advantage of the exchange-traded liquidity, traders are paying these hidden transaction costs, which can add up quickly. For example, even when normalizing for changes in the value of the underlying portfolio and controlling for long-term fund AUM trends, we estimate high yield bond ETFs may have cost investors over 1% in hidden transaction fees on an annualized basis in 2015.
It’s important to note that we are not suggesting that ETFs are bad investments. We prefer to explore for whom they are appropriate, and more importantly, for whom they are not a fit. If an investor is seeking a short-term way to trade in and out of an asset class, it’s difficult to imagine any vehicle easier than an ETF. However, for strategic investors seeking to adjust exposures within an asset allocation, they should be aware that they may be the ones left paying the hidden fees triggered by higher frequency traders.
By Venk Reddy
Originally published in Q3 2015 letter
1 A “round-trip” trade is one in which an investor buys a security and then subsequently sells the same quantity of the same security, thus completing the “round trip”.
2 A bid/offer spread for a security is the difference between where a security can be sold in the open market (the bid) and where it can be bought (the offer).
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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