More about ETF liquidity and the underlying assets’ liquidity

Sorry for the ridiculous title.  Not clickbait.

Noah, from Noahpinion, posted at Bloomberg, which was reposted at wealthmanagement.com:

It’s Smart to Worry About the Risks ETFs Pose

Remember how mortgage-backed securities turned out?
Now *that’s* a clickbait title.
The article is actually a lot more interesting than the title implies.

My own biggest worry about ETFs revolves around liquidity.

There is no single unified definition of liquidity. In general it means the ease with which you can trade an asset, but that depends on conditions in the market — mortgage-backed securities were plenty liquid before the crisis struck, but became incredibly illiquid once people started doubting the quality of their ingredients.

ETFs look very liquid, because as the name implies, you can trade them on exchanges. Take a thousand hard-to-trade bonds and pile them into an ETF, and you suddenly have one bond fund that the lowliest retail investor can buy and sell at will.

But what happens in a crisis? Suppose some bonds turn out to be a lot lower-quality than most investors believed. Without ETFs, those bonds would plunge in price, but other bonds would be fine. But now imagine that both the bad bonds and the good bonds are all bundled into ETFs. Now, when the bad bonds are discovered to be bad, investors who ignored the composition of their funds will suddenly wake up to the fact that they might contain toxic assets. Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don’t.

With assets like stocks, this isn’t so much of a danger — when stocks go bust, everyone can see which ones are bad. But when the ingredients in an ETF are complex, highly heterogeneous assets, as is the case with many bonds and derivatives, one ETF might be fine while another is worthless, and yet investors may ignore the differences until it’s too late.

Another possibility, pointed out to me by a friend in asset management, is that some of the individual securities in an ETF might start to have their own liquidity problems. If banks or other big broker-dealers suddenly become unwilling to facilitate the trading of certain kinds of bonds, ETFs that include large amounts of those particular bonds might suddenly plunge in price. Investors now buying up ETF shares might not realize that danger, thus leading to general overpricing.

So the more bespoke and exotic markets ETFs expand into, the greater the worry that they could be involved in a 2008-style liquidity crunch. That could pose risks for key financial institutions that hold ETFs, and it could also spell danger for individual investors’ retirement savings.

A few people are already worrying about this possibility, which is good. The more we worry about financial innovations in advance, the less chance we’ll need a crisis to teach us the limits of those innovations.

This is sort of the flip side of my earlier post regarding bond mutual funds vs. ETFs.  My assumption is that traders will quickly price in the illiquidity of the underlying assets.  His assumption is that they will not, or may not.  I think if you are investing in funds of illiquid assets, though, you are still better off in an ETF than a mutual fund if you are a buy and hold investor.  This article gives you even more reason to hold a mutual fund if you plan to sell into a downturn.

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ESG vs. Returns

Great post from Asness regarding ESG.  The bottom line is, if you are trying to encourage good behavior, you should expect that your goals do not come free of charge – there should be a cost to total returns.

Pursuing virtue should hurt expected returns. Some have discussed this fact. But, it’s still not widely understood or broadly accepted. This seems to arise from investment managers selling virtue as a free lunch, and from investors who very much want to believe in that story. In particular, and my focus here, accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it’s precisely the point (though its necessity may indeed be unfortunate). As an ESG investor this lower expected return is exactly what you want to happen and really the only way you can effect the change you seek

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Fed Balance Sheet unwind

Michael Arone at SPDR Blog has added a bunch of global data to the info I posted previously regarding the Fed’s balance sheet.  He includes some information about current and future levels of required reinvestments (maturity dates) but really doesn’t touch on how equity markets might be impacted.

There are a bunch of cool charts (and one really, really dumb one, click on the link and you figure out which one).

Here’s a couple:

growth_in_global_central_bank_assets_1160x760

us_treasuries_and_china_fx_reserves_1160x687

 

Importantly, he noted that the Chinese sale of treasuries was related to their desire to control the level of the yuan, not some general panic over US Treasuries, as that action is often portrayed.

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Electric Airplanes

From Real Assets Advisor.  Electric planes are under serious development.  This is amazing.  Will they be covered in solar energy capturing PV panels?  How can they carry enough batteries and still fly?

“Easyjet has had discussions with Wright Electric and is actively providing an airline operator’s perspective on the development of this exciting technology,” the airline told the BBC.

Founded in 2016, Wright Electric says the first plane, the Wright One, is being designed for flights that cover air corridors such as New York-to-Boston, London-to-Paris, and Seoul-to-Jeju.

“Our plane has to be so much cheaper that it’s a no-brainer,” the company wrote in a recent blog post. “For context, Boeing built the 787 to achieve 20 percent fuel savings over the 767. Fuel is such an expensive component of flying that 20 percent was considered sufficient to justify the development costs of a new plane. In our case, the Wright One has the potential to achieve fuel savings of as much as 50 percent.”

Wright Electric hired a team that had been previously funded by NASA to investigate the potential for electric planes, which company co-founder Jeff Engler says puts the startup years ahead of the competition.

 

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Fixed Income Investment Options

For fixed income exposure, there are currently 3 ways to own:  Hold the individual bonds, hold a bond fund, or hold a bond ETF.  Each has its advantages and drawbacks.

Depending on the type of bonds to be purchased, it may be difficult to achieve adequate diversification in individual bond holdings without a substantial investment (corporate and muni bond managers typically require at least $250,000).  Both mutual funds and ETFs provide maximum diversification with minimum investment.  ETFs have a slight edge here, as many funds do have investment minimums, and you only need to buy one share of an ETF.

Liquidity is another concern.  Again, individual bonds will have the least appeal for best execution.  ETFs have similar concerns, because the liquidity of an ETF is based on the liquidity of the underlying assets.  Bond funds can always be redeemed at NAV on a daily basis, so if you are interested in bonds that can be quickly bought and sold at NAV, regardless of bond market conditions, bond funds are the best choice.

Expenses and costs also vary greatly.  Individual bond portfolios, again, depending on the types of bonds, may be assembled at minimum cost, or may be managed for ongoing fees.  ETFs and funds have management fees, which vary from just a few basis points for index funds and ETFs to much higher fees for active funds.  It’s important to consider trading costs, including spreads and commissions, for ETFs (related to liquidity).

These basics are simple enough to determine, but they are not enough to make an informed decision.  For that, you need to consider why you own bonds, and when and how you plan to divest.  Is your investment process tactical, with buying and selling of positions?  Or is it more strategic, buy and hold?  Are you holding bonds to maturity in a bond ladder?

Consider the scenario of rising interest rates, forcing bond prices down, or, equivalently, a bond selloff in the type of bonds you own:

  • If you own the individual bonds and plan to hold to maturity, there is no practical impact on your portfolio. The bond values may drop, but the cash flows for your existing bond portfolio do not change.
  • If you own a mutual fund, you can redeem your shares daily at NAV. This option forces the fund company to either raise cash during downturns (a drag on performance), maintain credit for redemptions (an added cost), or sell assets, likely below NAV.  If you are selling tactically, you get the best price immediately.  If you are a buy-and-hold investor, you will bear the added costs of these sales and your investment may be harmed in the long run.
  • If you own an ETF, you can sell intra-day at market prices. The share creation/redemption process will force market prices for the ETF toward actual pricing of the bonds that includes costs of liquidity, so the ETF is likely to sell below NAV.  Investors who hold their shares are not impacted by these price movements.  Any fire sale pricing will be borne by the authorized participant who is redeeming the shares, and the individuals who are selling to the AP.

Bottom line:  If you are a buy and hold investor, an ETF or individual bonds may serve you best.  If you make tactical trades, the mutual fund daily NAV redemption feature is your friend.

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Better Than a New General Antibiotic

Scientists at Wisconsin are working on ways to kill just one species of bacteria.  They are starting with C. diff, but the technology could potentially be used for any bacteria.  From Futurism.com:

Jan-Peter van Pijkeren, a food scientist from the University of Wisconsin-Madison, is creating a probiotic cocktail that patients can swallow as a liquid or pill.

The cocktail of bacteria will include a bacteriophage – a virus that infects bacteria – capable of carrying a customized, false, CRISPR message to C. difficile. This message would cause C. difficile to make lethal cuts to its own DNA.

“The downside of antibiotics is they are a sledgehammer that depletes and destroys the gut microbial community,” van Pijkeren said to the University of Wisconsin-Madison. “You want to instead use a scalpel in order to specifically eradicate the microbe of interest.”

CRISPR is ideal for this use because such drugs would be very specific to the user. They could kill a single species of germ while leaving good bacterial untouched. In contrast, regular antibiotics kill off both good and bad bacteria, leading to resistance. If proven successful, CRISPR could become, not just the world’s most effective gene editing tool, but also the best bacteria-killing technology available.

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Health Insurance Hacks

As Obamacare becomes prohibitively expensive, here are some ideas of ways to at least partially insure yourself against catastrophic healthcare costs.  From Patrick Watson, via John Mauldin:

Insurance Hacks

I suggested looking for short-term medical coverage if Obamacare becomes unavailable in your area. Reader Mike E., a Colorado insurance broker, added some details.

Temporary insurance will probably continue to be available since it’s not under the ACA restrictions. But there are several caveats:

Not only will it not cover preexisting conditions, many of the temp insurance carriers will deny any coverage if you show preexisting conditions on your application form, even common things like moderate hypertension. Leaving such details off the application is a risky prospect, because the carrier can deny all claims if they find you’ve falsified information. And if they’re receiving major claims, they’ll probably look for a reason to deny them.

The biggest downside is the total benefit limit. As far as I know, there are no plans available with a limit above $2 million. Nonetheless, temp insurance is a good option if you can qualify.

Some readers may be in a position to change their permanent residence (e.g., to a second home). Traditionally, the choice of which to use has been based on state tax rates, but now access (and cost) of health insurance may be a bigger factor.

We have been selling quite a few “microgroup” plans, partly because group insurance is the only way to get a PPO plan in Colorado for 2017. Generally, the carriers require at least two participants, one of whom has no ownership stake. (Some carriers apply other rules, including whether 1099 employees are eligible and count.) Apparently, the working population is overall considerably healthier than the non-working population, and thus the group health insurance market hasn’t seen the turmoil that the individual market has.

On small-group insurance, Ray H. said to consider using a PEO, Professional Employer Organization—what was once called employee leasing. I’ve been such an employee before (of John Mauldin, actually, many years ago) and we had big-company-style benefits. It’s worth investigating if you are self-employed.

Another idea: Go (or go back) to school. Some community colleges have student group health plans open to part-time students of any age. The rates are low because the group is mostly young—but you have to be a legitimate, enrolled student and pay tuition. That might outweigh the lower premiums.

Healthcare Cost-Sharing

From Richard J.:

Many thanks, Patrick for your letter this morning; it’s right on. And thank you for finally mentioning the religious healthcare alternative, which is getting little to no mention at all. I am relatively healthy and have been with an alternative care for 2 years now.

The savings are huge, bigger than all my investing profits during the same time, and if you’re healthy and following the suggestions in your letter, it is smart, it feels good to help others, and it’s good to know some program that really works is behind you. Keep on doing the good work.

Richard refers to the handful of religious cost-sharing cooperatives that received a special exemption in the Affordable Care Act. Participating in one satisfies the Obamacare individual mandate even though they are not “insurance” per se.

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