No Mean Sum

"Many shall be restored who are now fallen, and many shall fall who are now in honor." -Horace

Jun 22, 2015

Down The Bond Market Liquidity ETF Rabbit Hole – A Link-Fest


*Many of the articles linked to are from The Financial Times Alphaville column. You do not need to subscribe to the Financial Times to read them but you do need to be registered for a free account with the FT for access. 

Regular consumers of financial media will be aware; there has been much gnashing of the teeth over bond market liquidity lately. Actually this has been going on for years but recently has reached something of a crescendo as global bond markets have sold off in the wake of better economic data out of Europe.

In this post, I am going to briefly summarize some of the issues surrounding bond market liquidity and ETFs, as I understand them. As well as provide links to some thoughtful articles that cover the issues in greater detail.

What most of the articles about bond market liquidity have in common is a set of observations about changes in the structure of the bond market. The two statements (facts) that get liquidity hawks all riled up are:

  1. Broker / Dealer balance sheets have shrunk dramatically since the ’08 financial crisis. This means that dealers have much less capacity to step in and warehouse bonds during the time between one market participant seeking to sell and another showing up to buy.
  2. Bond ETF’s have become massive and are promising heretofore unprecedented bond market access and liquidity to investors.

Thus the question is begged; how can objective bond market liquidity be at an all time low, and simultaneously with ETFs, seem to be at an all time high? The hawks answer is that the perceived liquidity of ETF’s is an illusion.

How that illusion comes to exist is probably worth a post unto itself. But we’re not going down that road today. For now, I’d like to look at some related questions about ETF’s and their impact on the markets.

The first question is, given the lack of dealer liquidity, can markets handle a large ETF sell off? I.E. If and when investors decide to sell their hundreds of billions of dollars of passively managed bond funds, who will step in to buy them?

The short answer seems to be, basically no one, and value investors. This means that there is an increased probability that investors will only be able to sell their bond assets at a significant discount to the “intrinsic value”. This is good for value investors but not clearly good for anyone else. A dislocation in the bond markets would likely reverberate across other asset classes as well. That is called contagion, and it’s what regulators really don’t like.

Everyone knows there is less bond market liquidity but no one really knows how bad of a thing that really will turn out to be. In the meantime, I have a theory that bond market liquidity gets lots of press because it is a safe thing to worry about. As I see it, two things can happen;

  1. if you worry about bond market liquidity and something bad happens in the bond market you look smart and,
  2. if you worry about bond market liquidity and nothing bad happens to the bond market, no one is going to remember!

Thus, worrying about bond liquidity offers an asymmetric incentive structure for market pundits. Expect more worrying.


A slightly more esoteric question is whether rapid divestment by investors could threaten the integrity and/or solvency of the ETF products themselves.

When I refer to an ETF’s integrity being threatened, I mean any scenario that results in the ETF trading at a significant discount or premium to the value of the underlying pool of assets it was intended to track, for a meaningful period of time. Almost by definition, this could only occur if the creation redemption mechanism somehow broke down.

This is probably the more profound risk ETF investors face, and while it sounds much more benign than ETF insolvency, it is directly contrary to the fundamental value proposition of ETFs. The buyer of a investment grade bond market ETF want’s exposure to the underlying index or basket that the ETF has been created to track. Not the underlying basket, plus some extraneous risk factor(s).


Theoretically an ETF only issues shares once it has the basket of securities needed to represent those shares in house. Therefore, it should never be able to become insolvent because all the liabilities (shares) have corresponding assets (securities) in the ETF pool.

That is how I assumed ETFs worked but I should have known better because all those securities sitting in the ETF pool would just be sitting there, and if there is one thing Wall St can’t stand, it’s idle capital. So I was only slightly surprised when I learned that ETF’s actually lend out their securities to generate additional fees.

In fact, the fees on some of the ETF products are so low that it is estimated that some ETF managers earn more from lending out the underlying securities than they do from the expense fee the ETF charges investors.

Like a bank that makes loans against deposits, these securities lending practices could make an ETF vulnerable to collapse in the event of a substantial redemptions. Securities lending was one of the primary contributors to the collapse of AIG.

To be fair, mutual funds engage in securities lending as well. And there are regulations for both ETFs and mutual funds about how much securities lending is allowed. Even so, the practice does introduce the risk, however remote, that an ETF might not be able to satisfy its redemption requests in the event of a major and rapid withdrawals. As a general rule, the more efficiently capital is used, the more fragile things become.


I would like to make it clear that this post is meant to be a thoughtful link-fest of what could potentially happen, and not a prediction or indictment of the bond market and ETFs in general.

Most ETFs will probably turn out to be good investment vehicles, investors should just be cognizant that good does not constitute perfect. is an WhiteTree Investment Management, LLC publication. For information on WhiteTree’s managed accounts, please see

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Apr 23, 2015

Bring Up The Bodies – Spinning the Flash Crash


Regulators don’t like being embarrassed and the Flash Crash was an embarrassing episode for the people who are in charge of supervising financial markets. From a regulatory perspective, the problem with financial markets is that they are by their very nature distributed amongst many participants, and therefore it is very difficult to assign blame when something goes […]

Apr 5, 2015

Howard Marks – Links


Howard Marks is one of my favorite investment luminaries. I’ve read his book, “The Most Important Thing” twice and listened to the audio-book version more than once as well. Below you’ll find links to his talk at Google and his most recent memo on liquidity. The memo on liquidity is especially interesting because it is […]

Jan 8, 2015

Energy Recovery – $ERII – Insider Buying and The Fear of Missing Out


Energy Recovery Energy Recovery (ERII) was incorporated 1992 and went public in 2008. The company produces energy saving solutions for desalination plants. Over the past few years, it has been developing a number of products to address the needs of other fluid intensive industrial processes, mainly related to the oil and gas industry. Legacy Business […]

Dec 29, 2014

Elliot Management – Paul Singer Interview


Also from the NYT Deal-book Conference, an interview with Elliot Managements founder Paul Singer. I think there is a lot of truth to what he says about governments implicitly or explicitly allowing central bankers to do the heavy lifting in terms of economic policy.

Dec 26, 2014

Holiday Readings


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Dec 24, 2014

ALJ Regional – A Mini BRK In The Making?


Background ALJ Regional holdings is a micro-cap holding company. The company’s largest shareholder, Jess M. Ravich owns 47% of the outstanding shares and is also the Chairman. Mr. Ravich has had a long career as an investment banker, and thus far it seems he is putting that experience to good use in assembling the holdings […]

Dec 17, 2014

Readings – Healthcare In America – The Bitter Pill


If the test of a great article is that it makes you realize how ignorant you are, then “The Bitter Pill” succeeds brilliantly. Published in 2013, in Time Magazine of all places, this piece was recommended to me by a friend who works in the health insurance business as “the best summary of what is […]

Aug 21, 2014

Hellfire and Brimstone – Electromagnetic Swans and Some Thoughts On Hedging


Electromagnetic Swans Recently I have been re-reading Nassim Taleb’s Fooled By Randomness and The Black Swan. So I was primed when I saw the headline, “Elliot Warns of Greatest Danger in Electromagnetic Pulse”. Understanding my own bias, and the fact that at any given moment there will be at least ten different hedgefund manager’s warning […]

Mar 23, 2014

Weak Shorts, Weak Longs – My Mistakes of 2013


Preface “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Charlie Munger A lot of things went right in 2013. My portfolio handily beat the S&P’s stellar performance. But I don’t want to […]