Ever since we heard that some of the largest ETF issuers were lining up emergency liquidity lines to tap in the event all the retail money that's piled into things like HY debt suddenly decides to head for the exits, we've gone out of our way to explain just why it is that the likes of Vanguard would consider paying out redemptions with borrowed money as opposed to selling the underlying assets. 

The problem is that in the context of the post-crisis regulatory regime, banks are no longer willing to hold large inventories of securities and so, when a bond fund manager facing large outflows tries to transact in size, he or she will likely be confronted with an extremely thin secondary market. Rather than risk dumping a large amount of assets into a market with few buyers and thus facilitating a fire sale atmosphere, fund managers are considering paying out investors who sell with borrowed cash and selling off the underlying assets slowly as the market permits. 

ETFs and other portfolio products mask this problem as long as flows are diversifiable. That is, if fund manager A is experiencing outflows, that's ok as long as portfolio manager B is seeing inflows. However, once flows become unidirectional (i.e. everyone is selling), then managers will need to go and sell the underlying assets and that, in today's market, is a big problem. Thus, ETFs give the illusion of liquidity – that is, investors assume there's no problem because they can trade in and out easily, but should the flows suddenly all head in the same direction everyone will quickly discover that, as Howard Marks put it, an ETF “can't be more liquid than the underlying.”

Amusingly, a new academic study from researchers at Stanford, UCLA, and the Arison School of Business in Israel suggests that ETFs themselves are contributing to a lack of liquidity for the stocks they hold. Essentially, the argument is that increased ETF ownership leads to wider bid-asks, less analyst coverage, and higher correlations with broad market moves.