Beware sliced and diced ETFs: Fidelity’s Kate Howitt

Regulators will clamp down on complex exchange traded funds in the aftermath of the coronavirus crisis, a fund manager says.

Fidelity fund manager Kate Howitt Picture: Hollie Adams

Regulators will clamp down on complex exchange traded funds in the aftermath of the coronavirus crisis wreaking havoc on financial markets across the globe, Fidelity’s Kate Howitt has predicted, as she warned of risks posed by complicated and opaque ETF structures that have soared in popularity since the last financial crisis.

“It’s that ‘financial innovation’ where we slice and dice the risk and no one has to worry about it any more until you realise you’ve sliced and diced the contagion and spread it throughout the whole ­investment community,” Ms ­Howitt, who manages the $1.6bn Fidelity Australian Opportunities Fund, told The Australian.

“That ‘financial innovation’ is a late-cycle phenomena; it built up prior to the GFC with collateralised debt obligations. Today, the contagion is slightly different in that it is much more on the ETF structure side.

“There were plenty of us who were saying those models were broken, even when they were launched.”

Bond ETFs have been flashing warning signals in recent days, with some trading at historic discounts to their net asset values, raising concerns about the liquidity mismatch between the ETFs and their underlying assets.

One of the largest bond ETFs on the market, the Vanguard Total Bond Market ETF, earlier this month traded at a historic 6.2 per cent discount to its net asset value.

The price of ETFs should typically be aligned with net asset value, since it is replicating the underlying asset.

Part of the problem with illiquid ETFs was that they rely on models around bond liquidity that no longer existed, Ms Howitt said.

“Prior to the global financial crisis, investment banks would carry large inventories of bonds, so they could make a market in bonds,” she said. “If someone was a forced seller, say an ETF had to unwind bonds, they would take them on their balance sheet thinking they could sell them on.”

Post-GFC, regulators put high capital charges on market-making activity, which essentially shut it down. Investment banks are no longer market makers in illiquid securities.

A lot of today’s complex ETFs were structured with the belief that there would be someone to make a market and take the asset if you needed to sell.

Alongside the lack of market makers since the GFC, compounding the issue was that everyone was following the same models, Ms Howitt said. “That’s fine if everyone wants liquidity to buy and everyone’s buying on the way up,” she said. “But when the models turn, volatility goes up and the signals turn from buy to sell. Now everyone’s trying to sell and there’s no one who wants to take the opposite side of that trade.”

In recent days, investors have pulled net $US20bn ($33.6bn) from US bond ETFs, raising questions over the logic of creating liquid ­equity instruments with illiquid underlying assets.

The US Federal Reserve on Monday surprised the market by committing to buying corporate bonds and corporate bond ETFs. Investors are hoping the buying activity from the central bank will close the gap between prices and net asset values.

Looking at the recent market ructions, Ms Howitt said there was a “massive deleveraging” and unwinding of complicated structures taking place in the financial economy at the same time as the real economy was grappling with extraordinary shutdowns to economic activity.

“As you see this deleveraging happening, it becomes reflexive, where someone who’s got a really high amount of leverage, they become a forced seller, and to meet the cash calls they sell other assets,” she said. “That forces down the price of that asset and then you get to the point where by the time assets start to fall, maybe 50 per cent, then even people who had moderate levels of gearing start to get margin calls of one sort or another, and then they become forced sellers. The process goes on and on and reinforces itself.”

As the risk parity community dumps stocks and bonds, that would wash through to leveraged ETFs and eventually unleveraged ETFs, she warned.

“There were a number of regulatory changes after the financial crisis … we’ll definitely go through that process in a couple of years from now,” she said.

“A lot of people have been talking about the risks inherent in these products, but financial regulation is always closing the door after the horse has bolted. So there will be a clampdown on ETF structures and then someone will come up with a new form of financial ­innovation.”