Junk-bond ETFs created for retail investors have been hijacked by hedge funds using them to make broad bets on bond prices, causing roller-coaster distortions in the high-yield market. Funds designed for retail investors have morphed into hedging tools that sell off too suddenly, and in too great a size, for illiquid high-yield bonds to keep up.
Hedge funds now account for almost 30% of the holdings of junk-bond ETFs, according to research by J. P Morgan, more than any other kind of ETF category except emerging market equity.
And that has ended up particularly hurting retail investors, who end up taking a loss well after the fast-money hedge funds have gotten in - and out - of the market.
"The ETFs in high yield have a much greater impact on that asset class than the investment-grade ETFs have on the high-grade bond market," said Oleg Melentyev, head of credit strategy at Deutsche Bank in New York.
"That's because the high-grade market is so much bigger versus the size of the ETFs," he told IFR.
"Investment-grade ETFs have US $17bn of assets, and high- yield about US $12.5bn, and the underlying IG market is about three to four times larger than the high-yield bond market."
When fast money decides to bail out of ETFs, as happened in early July, the junk-bond cash market gets flooded with huge lists of bonds that the funds are desperate to sell in order to keep up with the large volume of share redemptions.
But it becomes impossible to find enough buyers in the chronically illiquid market to keep up with the rapid-fire pace of share redemptions.
Desperate and often indiscriminate selling ensues, which only serves to exacerbate volatility and spread-widening - and sends shockwaves rippling through to mutual funds.
J. P Morgan strategists believe that using ETFs as a liquid hedging tool can also directly result in later waves of selling by retail investors in mutual funds.
"Our analysis suggests that higher hedge-fund ownership of ETFs is associated with stronger causality from ETF flows to respective mutual funds," the bank's global asset allocation strategists said in a recent report.
It said ETF outflows tend to lead retail mutual fund flows by about a week, while investment-grade ETFs, with a smaller 17% ownership by hedge funds, have no lead-lag time with mutual funds.
And that means retail investors pay the price. In an earlier report JPM noted that the record one-week US $7.1bn outflow from high-yield funds from July 31 to August 6 was largely from retail mutual funds.
ETF outflows had already slowed to a comparative trickle by that point, with fast money accounts having pulled out weeks before - at higher prices than retail investors got.
Increasing numbers of institutional fund managers have also redesigned their investment strategies and portfolio mixes to take advantage of forced bond selling by ETFs.
"You can make a lot of money from buying things when ETFs blindly sell them, and you have seen increasing numbers of portfolio managers doing this," said Ashish Shah, head of global credit investment at AllianceBernstein.
"That's the reason why the high-yield market has come back so quickly," he said.
"We have always been able to take a contrarian view. But the difference today is, with the ETFs you can make a lot more money being a contrarian than you could in the past."
Moreover, the red-hot market has squeezed out almost all of the profits to be had from spread tightening.
As a result, fund managers rely more heavily on turning moments of acute illiquidity into opportunities to generate alpha.
To do so, they are moving away from old-style single-asset investment products and taking up multi-asset investment strategies that allow them to sell high in one asset class in order to take advantage of illiquidity in another.
"The tighter spreads and yields get in bond markets, the more you need to rely on making money by being tactical," said Michael Collins, senior investment officer and credit strategist at Prudential Fixed Income.
"And the best way of being tactical in the illiquid markets of today is to make that illiquidity work in your favour."
Because ETFs are a single-asset vehicle, much of the volatility they created in the past was typically confined to high yield.
That meant institutional investors were able, for example, to sell Triple A CLOs at 70bp over Treasuries and then use the proceeds to pick up junk bonds offered at 350bp.
Collins said he expected many more moments of illiquidity going forward, with banks no longer the market-makers they once were - and as company fundamentals deteriorate across the normal maturation of the credit cycle.
"These bouts of selling have been magnified in an illiquid market," he said.
"Over the next five years we expect there will continue to be these predictable moments of volatility that will present opportunities to sell high and buy low." A version of this story appears in the August 23 edition of IFR Magazine.
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