LONDON A wild ride for bond markets since the U.S. election has re-ignited concern about a liquidity crunch in parts of the exchange-traded funds market, home to a small but fast-growing slice of global assets.
Despite weathering several shocks since the 2008-9 crisis, the jury is still out on how the funds - which trade as shares and aim to replicate the price of a basket of bonds or other assets - will react if another cataclysm hits.
The big question for 2017 is whether the bond market flux seen after Donald Trump won the U.S. presidential election turns into a tougher test as interest rates rise, especially as fears grow of another political crisis in Europe.
Concern derives in part from the industry's explosive growth in the past three decades, to $11.3 trillion in 2015. With investors attracted by their low fees, ETF assets will total $23.2 trillion in 2020, consultancy PWC predicts.
Many also draw parallels with asset-backed securities. When the market for the assets underlying those products dried up in 2008, banks holding them were forced almost overnight to mark their value down to zero. That led to a crisis whose fallout is being felt almost a decade on.
ETF providers say the concerns are overblown and the market actually helps investors by setting a price for assets that may not actively trade in the underlying market.
But Frederic Lamotte, chief investment officer at wealth manager Indosuez, calls the ETF market "a crisis waiting to happen". While he sometimes uses equity ETFs for tactical trades, he has banished bond ETFs from his 110 billion-euro portfolio.
"When someone wants to sell an ETF and no one wants to buy, the price can fall sharply when there are no fundamental issues with the underlying assets," he said.
His concerns centre on ETFs that track illiquid assets, particularly high-yield corporate debt or that issued in emerging markets, where a bond may not trade in size for weeks or months.
That very ability to buy and sell an illiquid asset with the ease of a share has seen ETFs dedicated to emerging market debt grow four-fold since 2011 to $35 billion, fund research house Morningstar estimates. High-yield, or 'junk' bond ETFs, meanwhile, are at almost $60 billion from $18 billion in 2011.
But these sectors and dedicated ETFs have expanded at a time of shrinking trading volumes, as tough rule changes after the 2008 crisis hit banks' ability to trade on their own account.
Ajith Nair, who advises institutional clients on fixed income investing at KPMG, said the ETF model had not been tested for an extreme scenario, where liquidity dries up.
Although they have fared well in smaller tests, including during the 2013 selloff, it is unclear how the products would react to a bigger, more protracted shock, he said.
And if bond ETF assets in 2008 were roughly on par with what market-making banks held on their books, ETFs today have 38 times more bonds than banks, Lamotte notes.
The fear is both that panic-selling of ETF units could spread across the wider market and that too big a gap may open up between the value of the ETF and its underlying assets.
Ordinary mutual funds can guard themselves to an extent by holding part of their portfolio in cash, an option not available to most ETFs.
Those concerns have prompted the U.S. Securities and Exchange Commission to look more closely at how many liquid and illiquid assets ETFs should be required to hold.
Providers, though, point out that ETFs are a fraction of the size of cash-bond markets, limiting contagion. The ETF structure has also proven to act as a shock-absorber in periods of stress, they say.
The first line of defence is that, like any share, the ETF allows a range of investors to invest at the same time, limiting large falls as value hunters move in.
"At times of volatility in the market, we're seeing spikes in the volumes of ETFs being traded," said Patrick Mattar, head of European broker dealer sales and execution services at iShares, part of BlackRock, the world's biggest asset manager.
"So, at the point where on a price basis people are really attracted to go and trade, and trading the underlying could be tested, trading the ETF is increasingly a very practical route for access."
The second line of defence is the ability to redeem ETF shares if the market maker - a bank or other 'authorised seller' - thinks ETF prices have fallen too far relative to the underlying assets.
If this happens, the market maker can hold the ETF units back until the market recovers, matching the risk with a derivative contract.
They could also exchange units with the ETF provider for cash or the underlying assets, which they can either sell, pass on to the end investor or hold until prices recover.
So far, this has worked well. But KPMG's Nair warns that a complete liquidity crunch is yet to test market makers' willingness to perform as such.
"They'd have to sell it into a market that's going down – in that worst-case scenario, although the secondary market could still operate, these primary market makers could evaporate."