Not long after Leighton Shantz joined the $26 billion Employees Retirement System of Texas, Austin, as director of fixed income in April 2012, his review of the nearly $6 billion bond portfolio called for a shift in strategy. Moving to a bifurcated mandate of “rates” and “credit,” however, would take some massaging of the existing core-plus fixed-income portfolio.
The primary problem: how to liquidate $2.8 billion worth of investment-grade bonds. Selling off individual securities would take too long and expose the fund to the whims of Wall Street fixed-income desks.
As an alternative, Mr. Shantz turned to exchange-traded funds for the transition.
ETFs have emerged as a warehouse for fixed-income securities and a utility for institutional investors to move in and out of individual bonds en masse without giving up price. What follows are excerpts of a conversation with Mr. Shantz on how he steered into and out of ETFs.
How did you view the fixed-income portfolio initially? We're a mature plan. ERS monetizes every month to make benefit payments, and we'd prefer not to sell good assets at below intrinsic value. We were buying bulletproof bonds, but in a liquidity crisis they go no-bid. When fixed income can't provide returns, it has to serve as an anchor. Yet, if in a tail-risk scenario you lose five percentage points when you sell, that asset isn't really an anchor. At this stage of the market cycle, our investment-grade holdings just didn't fit and we needed to get out. Given the state of primary dealer balance sheets, we made the assumption that if something goes bad, we've got a problem and the only option becomes that they mature.
That clearly isn't your preference. So, how did ETFs become part of this transition? Well, we knew that fixed-income ETFs could be created in bespoke baskets. In an ETF, we could sell in whatever manner we chose to effect
this change. We approached an ETF issuer and presented our holdings, asking which they could take in bespoke baskets and what ETFs would come back. It was an iterative process, with several proposals, before we came to baskets and ETFs that worked for both sides.
But you ended up following through? Yes, the whole process took about nine months. We chose to just keep anything maturing in three years and then narrowed the ETFs down to two. We determined what securities the ETFs could accept and how many shares of the ETFs we'd get back. It would all happen on one day. The authorized participant had to take the bonds, deliver them to the fund and give us the shares.
How did you verify that the transaction was successful? The bonds we delivered in, we marked at the bid at the end of that day against the net asset value of the ETF. We looked at the price of every single bond to make sure their marks weren't skewed against us. We actually delivered a slightly less risky portfolio than we took back, but we got paid for it and bore that risk. The liquidity trade-off was worth it.
These were sizable creations for any ETF. Did anyone notice? In one of those ETFs, we disrupted the market in terms of assets. It jumped over half a billion overnight. So we laid low as our positions hadn't been filed yet, and then started selling down within market liquidity constraints. No one seemed to know what we were up to. We also did a few off-market transactions. Another authorized participant was short shares of an ETF we owned, and we were able to supply it at an advantageous price; we were effectively outed to the Street at that point. Today, we are out of those transitional ETFs.
Have you considered ETFs in other parts of the fixed-income portfolio? When we created the credit mandate, and before we had an internal team, I wanted to start that book growing, so ERS built up a position in high-yield bond and emerging markets debt ETFs. We were uncomfortably underweight the sectors and thought there was value. Building internal expertise in high yield takes time, so we used an ETF as a proxy.
Do you have any worries about the ETF market? I have sincere concerns that there's a little smoke and mirrors going on when ETFs appear to be significantly more liquid than the underlying assets. At the limit, that's not going to work. For instance, leveraged loans have about a 21-day settlement, but the ETFs are at T+3. If you get a run on those things, someone is going to get left holding the bag.