Illiquidiity scenarios for Mutual Funds/ETFs

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SlowMovingInvestor
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Illiquidiity scenarios for Mutual Funds/ETFs

Post by SlowMovingInvestor » Thu Aug 09, 2018 9:22 am

I was thinking of converting some Vanguard Mutual Funds to ETFs, and I was wondering about whether there might be a difference in bad case scenarios when the underlying holdings become really illiquid.

MFs are required to redeem daily. I know of one case (Third Avenue Focused Credit Fund) which was unable to redeem the securities, so the fund was frozen for around 15 months (no redemptions), and gradually liquidated as the securities were sold slowly.

But what about happen for ETFs ? Would there just be a massive discount from 'NAV' ? Would the firms that convert ETF Units into the underlying chose to bow out if they don't want to take the risk of holding illqiuid underlying securities after redemption ? Do they have a contractual obligation to provide this service indefinitely ? Can one just rely on the market to maintain some liquidity in such an instance ?

For highly liquid ETFs like VGs, this may seem a remote possibility, but underlying holdings for some fixed income and international ETFs are not that liquid.

Is there some sort of increased risk in an illiquidity scenario in ETFs rather than MFs ? As I point out above, even MFs have been frozen in such instances, so there may not be much difference. And for VG, where ETFs are just a share class of MFs, the MF and the ETF may just sink and swim together.
Last edited by SlowMovingInvestor on Thu Aug 09, 2018 12:04 pm, edited 1 time in total.

livesoft
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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by livesoft » Thu Aug 09, 2018 9:40 am

There have been liquidity problems with Vanguard ETFs. All you have to do is research "flash crash" and you will get to read about the problems. A flash crash is a short-term lack of liquidity that happens intra-day. They can be very profitable for folks who can buy during those times.
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SlowMovingInvestor
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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by SlowMovingInvestor » Thu Aug 09, 2018 9:44 am

livesoft wrote:
Thu Aug 09, 2018 9:40 am
There have been liquidity problems with Vanguard ETFs. All you have to do is research "flash crash" and you will get to read about the problems. A flash crash is a short-term lack of liquidity that happens intra-day. They can be very profitable for folks who can buy during those times.
I'm not too concerned about intra-day liquidity, since I'm not an active trader and use limit orders to sell.

I am more concerned about a scenario where NAV diverges significantly from market value and there is no way to sell at NAV for months, even years. The ETF becomes more like a closed end fund then. The question is whether there is some advantage to being in an MF in such a situation, or would the MF also clamp down on redemptions (as Third Avenue's fund did) ?

alex_686
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by alex_686 » Thu Aug 09, 2018 1:37 pm

I should point out that ETFs can sell their underlying securities like a mutual fund, and a mutual fund can do the creation unit trick like ETFs. It is not their normal business processes but if things get sticky it is a option. Both happened during the 2008 liquidity crisis.

I think a mutual fund has more flexibility because it has a greater ability to deviate from the underlying index but there are issues there as well.

SlowMovingInvestor
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by SlowMovingInvestor » Thu Aug 09, 2018 2:37 pm

alex_686 wrote:
Thu Aug 09, 2018 1:37 pm
I should point out that ETFs can sell their underlying securities like a mutual fund, and a mutual fund can do the creation unit trick like ETFs. It is not their normal business processes but if things get sticky it is a option. Both happened during the 2008 liquidity crisis.

I think a mutual fund has more flexibility because it has a greater ability to deviate from the underlying index but there are issues there as well.
My thought on this is that since MFs have a regulatory requirement to allow redemptions daily, they are more likely to aggressively take steps to maintain liquidity or at the very least to ensure some money gets returned to shareholders in a liquidiation (ike the Third Avenue Value fund I mentioned).

I'm not sure if ETFs have any such requirement. If ETF NAV diverges very significantly from market value, could the ETF company (in theory) just say -- sorry, it's not our problem, and run the ETF essentially like a Closed End Fund ? Do they actually have any legal obligation to provide liquidiity ?

This may be a more theoretical than real issue -- a major fund sponsor like VG or Blackrock would somehow try and maintain some liquidity and get NAV close to market value for reputational reasons, if nothing else, but I still wonder if this extreme case is somehow relevant in the regular MF vs ETF debate.

alex_686
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by alex_686 » Thu Aug 09, 2018 2:44 pm

SlowMovingInvestor wrote:
Thu Aug 09, 2018 2:37 pm
My thought on this is that since MFs have a regulatory requirement to allow redemptions daily, they are more likely to aggressively take steps to maintain liquidity or at the very least to ensure some money gets returned to shareholders in a liquidiation (ike the Third Avenue Value fund I mentioned).

I'm not sure if ETFs have any such requirement. If ETF NAV diverges very significantly from market value, could the ETF company (in theory) just say -- sorry, it's not our problem, and run the ETF essentially like a Closed End Fund ? Do they actually have any legal obligation to provide liquidiity ?

This may be a more theoretical than real issue -- a major fund sponsor like VG or Blackrock would somehow try and maintain some liquidity and get NAV close to market value for reputational reasons, if nothing else, but I still wonder if this extreme case is somehow relevant in the regular MF vs ETF debate.
For the first 2/3 of your post - yeah - kind of. You put it more aggressively than I think is correct but these are debatable points.

You last point is a bit off. I think the internal dynamics for a sponsor to keep a fund liquid is equal for mutual funds and ETFs. I can think of some exceptions during 2008 where sponsors propped up money market mutual funds so they would not "break the buck" but that is about it.

not4me
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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by not4me » Thu Aug 09, 2018 3:29 pm

SlowMovingInvestor wrote:
Thu Aug 09, 2018 9:44 am


I am more concerned about a scenario where NAV diverges significantly from market value and there is no way to sell at NAV for months, even years. The ETF becomes more like a closed end fund then. The question is whether there is some advantage to being in an MF in such a situation, or would the MF also clamp down on redemptions (as Third Avenue's fund did) ?
I'm having a hard time thinking of a scenario where this would persist for months or years & I don't see it equating to a closed end fund. The 3rd Ave fund sure didn't as they liquidated -- a process that started not long after the redemption clamp if I recall correctly. In that case, the underlying assets were so illiquid I imagine there was question about the validity of the NAV anyway. You mentioned bond & international as possibles -- are you then thinking of MFs/ETFs that have mainly highly illiquid assets?

And are you thinking strictly of exchange traded FUNDS? You may recall earlier this year a volatility exchange traded NOTE was liquidated in a well publicized incident

OP, is this mainly theory or are you weighing some specific pros & cons? If this is a con, why not just stick with the MF? I would think if they are truly that illiquid there'd be few pros to going with the ETF version. And to be honest none of the Vanguard funds come to mind as candidates

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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by Dale_G » Thu Aug 09, 2018 3:45 pm

Flash Crash aside, in the event that the EFT version of a Vanguard mutual fund trades at a significant discount to NAV, the mutual fund itself could buy the ETFs and sell the underlying securities from the mutual fund account.

And I will be happy to convert my mutual fund shares to ETF shares if I can do so when the ETF is trading at a significant discount to NAV.

Please let me know when it happens.

Dale
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SlowMovingInvestor
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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by SlowMovingInvestor » Thu Aug 09, 2018 4:30 pm

not4me wrote:
Thu Aug 09, 2018 3:29 pm
SlowMovingInvestor wrote:
Thu Aug 09, 2018 9:44 am


I am more concerned about a scenario where NAV diverges significantly from market value and there is no way to sell at NAV for months, even years. The ETF becomes more like a closed end fund then. The question is whether there is some advantage to being in an MF in such a situation, or would the MF also clamp down on redemptions (as Third Avenue's fund did) ?
I'm having a hard time thinking of a scenario where this would persist for months or years & I don't see it equating to a closed end fund. The 3rd Ave fund sure didn't as they liquidated -- a process that started not long after the redemption clamp if I recall correctly. In that case, the underlying assets were so illiquid I imagine there was question about the validity of the NAV anyway. You mentioned bond & international as possibles -- are you then thinking of MFs/ETFs that have mainly highly illiquid assets?

And are you thinking strictly of exchange traded FUNDS? You may recall earlier this year a volatility exchange traded NOTE was liquidated in a well publicized incident

OP, is this mainly theory or are you weighing some specific pros & cons? If this is a con, why not just stick with the MF? I would think if they are truly that illiquid there'd be few pros to going with the ETF version. And to be honest none of the Vanguard funds come to mind as candidates
Your question -- why not stick with MFs -- is very valid. I want to move some funds to another brokerage to get a bonus of a few thousand $. I don't want to liquidate for tax reasons. Not all brokerages allow Admiral Funds to be transferred, and many will charge for selling. ETFs are totally liquid for moving to other brokers, that's why I want to convert.

I'm trying to think through if there is some sort of serious negative in conversion from MF to ETF (which is a one way conversion) that might manifest in a down market situation. Fund sponsors have certainly been willing to let closed end funds trade at discounts to NAV -- could ETF sponsors decide to do the same ? Many of the counter-arguments mentioned here about reputational risk to the sponsors are quite convincing, so I'm probably just being excessively nervous.

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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by not4me » Thu Aug 09, 2018 4:47 pm

SlowMovingInvestor wrote:
Thu Aug 09, 2018 4:30 pm

Fund sponsors have certainly been willing to let closed end funds trade at discounts to NAV -- could ETF sponsors decide to do the same ? Many of the counter-arguments mentioned here about reputational risk to the sponsors are quite convincing, so I'm probably just being excessively nervous.
I understand about the transfer. As for it being comparable to closed-end, I'm still not convinced this is apples to apples. Due to wide range of closed-end funds, I hesitate to speak too broadly. But, consider why they trade at a discount when they do. Some may be in recognition for underlying illiquid assets. But some is attributed to the leverage in use & affect that has or is expected to have. Some may be for extended times due to the type (that is, all MLPs, or REITS, etc) & then swing to a premium down the road. ETFs trade at discount/premium all the time -- just not chronic for years & years. I'm not an expert on closed-end & trying to learn. Maybe it is a matter of degrees -- extent of discount & length of time.

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Re: Illquidiity scenarios for Mutual Funds/ETFs

Post by alex_686 » Thu Aug 09, 2018 5:02 pm

SlowMovingInvestor wrote:
Thu Aug 09, 2018 4:30 pm
Fund sponsors have certainly been willing to let closed end funds trade at discounts to NAV -- could ETF sponsors decide to do the same ? Many of the counter-arguments mentioned here about reputational risk to the sponsors are quite convincing, so I'm probably just being excessively nervous.
To extend on this a little bit, open ended and closed ended funds are governed by different regulations. Closed end funds can trade at a discount for years and the regulators don't care - it is not part of their preview. Open ended funds - which included both mutual funds and ETFs - can't. Their is a fair amount of regulation surrounding their liquidity.

Yes, their are times when these rules are suspended. However, when this happens the choices a fund has is some combination of fixing the issue or liquidating the fund. You can't issue new shares or grow the fund - only shrink it. This is not a situation a fund sponsor wants to be in for the long term.

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JoMoney
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by JoMoney » Thu Aug 09, 2018 5:59 pm

In-Kind Redemptions and Mutual Fund Investments :
https://www.thebalance.com/in-kind-rede ... nts-357956

SEC rule 22e-4 "Investment Company Liquidity Risk Management Programs"
https://www.sec.gov/rules/final/2016/33-10233.pdf

Interesting Vanguard comment:
https://pressroom.vanguard.com/nonindex ... 010615.pdf
...The mutual fund industry has a strong record of satisfying shareholder redemptions in equity and
fixed income funds over the past 75 years, which included periods of market turbulence and decreased
levels of market liquidity. While academic theories have speculated about the possibility that mutual
funds pose significant liquidity or redemption risks, the Commission presents no data to support these
theories.
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by jhfenton » Thu Aug 09, 2018 6:43 pm

Dale_G wrote:
Thu Aug 09, 2018 3:45 pm
And I will be happy to convert my mutual fund shares to ETF shares if I can do so when the ETF is trading at a significant discount to NAV.

Please let me know when it happens.

Dale
You would not want to "convert" in that case, because Vanguard converts at NAV. You would want to buy the heavily-discounted ETF and sell the mutual fund.

But Vanguard ETFs don't trade at persistent discounts. They seldom trade at any significant discount. There are a few ETFs that typically trade at a premium (notably VSS - Vanguard FTSE All-World ex-US Small Cap), and it is possible to arbitrage those (e.g. sell VSS at a premium and buy VFSVX at NAV, then convert VFSVX to VSS at NAV a few days later).

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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by Dale_G » Thu Aug 09, 2018 7:09 pm

jhfenton wrote:
Thu Aug 09, 2018 6:43 pm
You would not want to "convert" in that case, because Vanguard converts at NAV. You would want to buy the heavily-discounted ETF and sell the mutual fund.
Yes, of course. My arbitrage brain lobe was asleep.

Dale
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VaR
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by VaR » Thu Aug 09, 2018 7:27 pm

Vanguard has previously said they were uncomfortable with offering an ETF on potentially illiquid junk bonds because:
1. ETFs on junk bonds tend to trade at a premium to NAV when money is flowing into the asset class and at a discount to NAV when money is flowing out of the asset class. “Those swings hurt the average investor if they're following the crowd,” said Ken Volpert, head of taxable bonds at Vanguard.
2. ETF's on junk bonds would be based on an index and Vanguard is uncomfortable running an index fund on junk bonds because of the requirement to track to the index would mean buying and selling potentially illiquid securities, leading to tracking error.

I feel like there's not a generality that we can derive from the question of specific scenarios of a liquidity crisis that might affect a mutual fund vs an ETF, other than the one from point #1 above - which says that you should be careful when trading an ETF if you think any of the underlying components have become illiquid. Note that this is the companion concern to the concern about mutual funds where you should be careful when trading them if you think one of the underlying is illiquid and thus the closing NAV is based on a "fair value" estimate of the illiquid securities.

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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by SlowMovingInvestor » Thu Aug 09, 2018 7:27 pm

JoMoney wrote:
Thu Aug 09, 2018 5:59 pm
In-Kind Redemptions and Mutual Fund Investments :
https://www.thebalance.com/in-kind-rede ... nts-357956

SEC rule 22e-4 "Investment Company Liquidity Risk Management Programs"
https://www.sec.gov/rules/final/2016/33-10233.pdf

Interesting Vanguard comment:
https://pressroom.vanguard.com/nonindex ... 010615.pdf
...The mutual fund industry has a strong record of satisfying shareholder redemptions in equity and
fixed income funds over the past 75 years, which included periods of market turbulence and decreased
levels of market liquidity. While academic theories have speculated about the possibility that mutual
funds pose significant liquidity or redemption risks, the Commission presents no data to support these
theories.
Interesting note from the SEC, and the Rule pretty much negates my concerns about ETFs. The Rule mentioned doesn't apply to Closed End Funds, and only in a limited fashion to Unit Investment Trusts (which is the point Alex made earlier about liquidity rules being stricted for MFs and ETFs).

Interesting too that Vanguard generally goes along with the mutual fund industry viewpoint most (all ? ) of the time even though it may strictly not be in accordance with the 'Vanguard Way'. Nothing sinister there -- idealism and practicalities conflict all the time.

As usual, very detailed and informative discussion on these boards even on a very technical point.

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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by jhfenton » Thu Aug 09, 2018 7:57 pm

Dale_G wrote:
Thu Aug 09, 2018 7:09 pm
jhfenton wrote:
Thu Aug 09, 2018 6:43 pm
You would not want to "convert" in that case, because Vanguard converts at NAV. You would want to buy the heavily-discounted ETF and sell the mutual fund.
Yes, of course. My arbitrage brain lobe was asleep.

Dale
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Johnnie
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by Johnnie » Thu Aug 09, 2018 8:53 pm

I asked the same question differently in a recent thread, "Are mutual funds safer than ETFs?" Lackey gave a pretty good answer (below) and also supplied the vocabulary I lacked when asking the question, "synthetic" funds vs. "physical." IOW, do ETFs really own the underlying shares?
viewtopic.php?f=10&t=252254

I'm mostly reassured when it comes to the big consumer-oriented fund sellers including VG, Schwab, Fidelity, etc. (My question referred only to ETFs, not the "ETNs and other exchange-traded products" which Lackey asked about.)
lack_ey wrote:
Thu Jun 21, 2018 7:04 pm
Johnnie wrote:
Thu Jun 21, 2018 6:29 pm
With ever more exotic ETFs appearing almost weekly, and at least one serious liquidity incident this year and a growing number of dark-warning articles, I can't help feeling good about having most of my portfolio in stodgy old mutual funds.
How inclusive is your definition or meaning of "ETF" here? Do you include ETNs and other exchange-traded products that might have other kinds of structures such as commodities pools, grantor trusts, etc.? Or just exchange-traded funds?
Johnnie wrote:
Thu Jun 21, 2018 6:29 pm
This is based on my belief that a mutual fund actually owns almost exactly the number of shares of individual stocks as my and every other fund investors' holding. (I expect they have a tiny bit of wiggle room at the margin for management efficiency.)
Some mutual funds may not.
Johnnie wrote:
Thu Jun 21, 2018 6:29 pm
In contrast, my belief about ETF companies is that they don't own shares, but are essentially using our money to make contracts that trade new investor dollars for promises to redeem them in the future at the then-current price of the "fund's" underlying components.
The vast majority of US-listed ETFs are physical and own the securities.

Overseas, mostly in Europe, it's more common to see synthetic (as opposed to physical) ETFs that do not actually own the securities and instead use derivatives to gain asset exposure say to more or less match an index. Usually this is with swaps. So I suppose there's counterparty risk but this is not with the fund company but with the megabank(s) the fund has the arrangement with.

In any case, check the holdings. All the big US ETFs hold the assets, even many not under the '40 Act structure. The ones that don't tend to be narrow commodities-oriented funds, inverse/leveraged daily return products, and the likes.

Also, there's no redemption mechanism for ETFs like that with individual investors. They don't set a price. The price investors get is whatever somebody else wants to buy or sell at on the market. It's a market price, not determined (much less promised) by the fund company.
Johnnie wrote:
Thu Jun 21, 2018 6:29 pm
But seriously, for those of us who don't care about being able to buy and sell during trading hours (a synonym for "Boglehead?"), is there any extra margin of safety in mutual funds?
Depends how you think and define safety. With respect to fraud, it's basically zero for both. Mutual funds can be more liquid in the sense of being able to transact at NAV on any day... not that there's any guarantee of what NAV will be, and subject to potential early redemption fees if applicable and some frequent-trading restrictions. With an ETF the price may be temporarily skewed one way or another in theory, though there are institutional arbitrage mechanisms for keeping that in line that work the vast majority of the time.

Though really, the daily liquidity at NAV of mutual funds can also cause problems that might not take down an ETF. Check back on what happened to Third Avenue Focused Credit.
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by jalbert » Fri Aug 10, 2018 12:35 am

Why do you wish to convert it to ETF shares? I could see doing that if you wish to do a transfer-in-kind of the asset to another broker. Otherwise, leaving it as a mutual fund preserves the option of holding it as either a mutual fund or ETF, as you could convert to an ETF if it ever became clearly advantageous to do so.

I think an ETF is unlikely to be more liquid at some point in time than the securities it contains are at that point in time. Being less liquid is certainly possible.
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by dpm321 » Fri Aug 10, 2018 8:01 am

Can it happen? Just look at what happened to the VIX ETFs not too long back.

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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by vineviz » Fri Aug 10, 2018 8:06 am

dpm321 wrote:
Fri Aug 10, 2018 8:01 am
Can it happen? Just look at what happened to the VIX ETFs not too long back.
Again, the thing you want focus on is the underlying asset and not the fund or ETF.

VIX futures contracts have very different risks than the S&P 600 Small Cap Index stocks, for instance.
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Re: Illiquidiity scenarios for Mutual Funds/ETFs

Post by AlohaJoe » Fri Aug 10, 2018 8:14 am

dpm321 wrote:
Fri Aug 10, 2018 8:01 am
Can it happen? Just look at what happened to the VIX ETFs not too long back.
XIV is the only thing that closed AFAIK.
It wasn't an ETF.

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