Was Monday’s ETF Collapse Just A Warm-up?

Back in March, Howard Marks offered the following rather straight-forward assessment of exchange traded funds: “The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.” 

That’s a warning that almost no one seemed to understand.

Well, that’s not entirely true.

Some ETF providers clearly understood because, as we noted with some alarm in May, Vanguard, Guggenheim, and others are quietly lining up billions in emergency liquidity that can be tapped in the event IG and HY bond fund flows suddenly become very non-diversifiable (aka unidirectional, aka everyone is getting the hell out in a hurry).

The problem, without subjecting readers to the entire backstory (which you can read here), is that thanks to lawmakers’ futile attempt to root out prop trading, dealers aren’t willing to hold any inventory anymore and so secondary market depth in corporate credit has collapsed, meaning the potential exists for large trades in the underlying to cause severe price distortions.

But while everyone focused squarely on corporate bonds funds and the potential for ETFs to exacerbate the problem by giving retail investors the illusion of liquidity when in fact, the underlying is extremely illiquid, not many people seemed to be aware that the very same thing could happen to equity ETFs should liquidity dry up in the underlying stocks.

Two points on this, i) Howard Marks’ assessment applies equally to equity ETFs; that is, the ETF cannot be more liquid than the underlying, and ii) thanks to today’s broken markets, there’s the very real potential for liquidity to suddenly disappear in stocks. 

Well, anyone who headed into last weekend still harboring the patently ridiculous idea that somehow exchange traded funds can be more liquid than the assets they reference was subjected to a terrifying dose of reality on Monday morning when suddenly,

Originally appeared at: http://davidstockmanscontracorner.com/was-mondays-etf-collapse-just-a-warm-up/