December 29, 2016

Carl Icahn warning on ETFs

What is dangerous are those ETFs that consist of relatively illiquid instruments--for example, municipal bond funds, junk bond funds and/or small-cap funds in biotech and in other areas--that are expected by many investors to be liquid.

But, an ETF cannot be more liquid than its component holdings.

So, when liquidity dries up--particularly in illiquid asset classes and industry-specific or market ETFs--there can be dangerous dislocations and markets easily can be disrupted. And these disruptions can have a tendency to build on themselves.

We have seen these sort of flash crashes of illiquid ETFs in the past; they are now starting to occur with greater frequency.

They almost never occur when markets are rising. They usually occur when stocks are sold off hard.

And, sometimes that sort of hard selloff/crash can be further exacerbated, as we have witnessed, by panicky ETF holders. When this occurs, the ETF manager can be forced to sell illiquid holdings in order to rebalance the portfolios. When selling intensifies, this causes illiquid ETFs to fall further.

In its extreme, this response even could cause selling in the more liquid ETFs as investors more broadly panic and sell.

Bottom Line

The risk of ETFs is that too many assume their ETFs are as liquid as or more liquid than their component holdings--not that they are inherently too popular, as Carl Icahn has suggested.

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