Recent shifts in the leveraged loan market have once again spotlighted a constant for all exchange-traded products: complexity increases as the liquidity of the underlying assets decreases.
For ETPs, the lesson comes up every few years as the asset classes available to investors expand, starting with emerging market equities, then high-yield debt, on to municipals and finally to leveraged or senior loans.
With the introduction of each asset class, ETP investors of all sizes and experience had to tackle both the characteristics of the underlying securities held by the ETP as well as the multiple levels of liquidity of the ETP itself. The primary market for ETP shares is limited to authorized participants who engage directly with a bank or fund distributor to create and redeem shares in bulk at net asset value. In the secondary market, both on and off exchanges, ETP shares are traded at negotiated prices.
It's no surprise, then, that institutional investors and asset managers large enough to hold some of these assets directly rarely participate in the more fringe exposures offered through ETPs.
Leveraged loan exchange-traded funds have grown significantly since the March 2011 launch of the PowerShares Senior Loan Portfolio (BKLN), based on the S&P/LSTA U.S. Leveraged Loan 100 index. Four funds collectively hold nearly $8.2 billion in leveraged loans, with $7.2 billion in BKLN. Such assets, which can take several days to weeks to trade and settle, are traditionally syndicated to and held by mutual funds or hedge funds.
According to S&P CapitalIQ/LCD, S&P/LSTA index loans outstanding grew to nearly $750 billion at the end of May, up 33% in one year. The category also saw a 61% increase in assets managed internally by U.S. institutional tax-exempt investors to $34.4 billion, according to Pensions & Investments research.
According to Lipper, mutual funds and exchange-traded funds held $148.6 billion in leveraged loans as of May, but recent withdrawal activity of $3.7 billion for the six weeks ended June 11 have caught the attention of both investors and regulators.
From mid-April through early June, BKLN saw nearly $256 million in outflows across nine days, according to data from research firm ETF.com. At the same time, fund shares closed for several days at a discount to net asset value, approaching 30 basis points at times. Over the past 18 months, BKLN shares had primarily traded at a small premium as net asset flows to the fund eclipsed $5 billion. The second biggest bank loan fund the $609 million actively managed SPDR Blackstone/GSO Senior Loan ETF also traded to a discount during the late May period.
Although notable, this experience is not uncommon in areas of fixed income and other investments when liquidity and settlement for the fund or trading vehicle is greater or faster than the liquidity and settlement for the underlying assets.
When evaluating non-core exposures in ETFs, investors need to have a much better understanding of the underlying liquidity, said Deborah Fuhr, partner and co-founder of London-based research firm ETFGI. Most investors don't grasp this until they handle their first trade or have had a reason to really dig in.
Floating-rate, leveraged loans and bank debt-based investments had been in demand in 2013 when interest rates were expected to rise more swiftly. But decreasing yields in less-risky areas of fixed income more recently turned enough investors away from loans at the end of May that the ETFs hit a sustained discount to NAV.
The same dynamic in municipal fixed-income ETFs last year prompted Mark Wiedman, BlackRock Inc.'s global head of iShares, to declare in a client letter that more and more, ETFs are becoming the true market, implying that ETF prices can lead the underlying assets in times of market stress.
Investors with a long-term view on a less liquid asset class, therefore, might not be particularly well served by an ETF.
In less liquid asset classes, such as high-yield debt and loans, we prefer active investment managers who are able to respond to complex markets and illiquidity; those who are credible and can dictate terms, said Michael Scotto, partner with Hewitt EnnisKnupp's global asset allocation team in Norwalk, Conn. Liquidity, transparency and structure significantly inform the types of ETPs we recommend to clients, he adds. n