While there have been many theoretical explanations why the passive ETF bid for bonds is a ticking timebomb, with Oaktree’s Howard Marks perhaps making the best arguments ever since his March 2015 thought experiment in which he asked what would happen if ETF holders “sold all at once” resulting in a bidless market, a more tangible – if simple – explanation has come from the head of global ETFs at Franklin Templeton who stated simply that fixed-income indexes are now “broken,” which makes active management a necessary component for successful bond ETFs.
“Investors typically have gone into passive fixed income primarily because that’s all there was,” Patrick O’Connor said Thursday in an interview on the sidelines of the Inside ETFs Canada conference in Montreal quoted by Bloomberg. “But as a firm, and as an active manager, we don’t just think indexes are flawed in fixed income, we think they’re broken.”
Here is the paradox: according to O’Connor, the weight of individual securities in fixed-income indexes is often determined by debt issued, meaning companies that issue more debt will have a higher weight in an index-based ETF.
In other words, the more debt a company has, the more of it has to be owned by a passive investor simply due to the quirks of capital allocation.
“That doesn’t necessarily mean they’re the best companies, but they would be the ones that a passive manager would have to overweight,” said O’Connor, who manages Franklin Templeton’s $1.5 billion ETF platform.
Think of it as a way the passive industry rewards excess leverage, and since there are trillions in “dry powder”, it may explain why the market continue to bid up debt even as it approaches unsustainable levels. Commenting on the Goldman chart below, two weeks ago we said that the reason “why nobody cares that corporate debt is all time high: because the market rewards it.” Today we confirmation.
There is another problem facing passively managed bond ETFs: the indexes they track often mechanistically add securities simply when the debt is upgraded and prices rise, and remove securities when the debt is downgraded and prices fall, according to Don Suskind, head of the ETF strategy team at PIMCO
“So you’re a forced buyer after the price has gone up, you’re a forced seller after the price has gone down,” Suskind said, speaking on a panel at the Inside ETFs conference.
Going back to Howard Marks’ original argument, what is most concerning is that in the past decade there has never really been a full-blown “forced seller” market to test just how stable the ETF architecture truly is, as central banks have traditionally intervened at key moments of market weakness. With central banks now tightening across the globe, this may no longer be the case.
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