The 'Hotel California' Flap: ETF Investors Should Take It Easy

The Eagles’ multi-platinum "Hotel California" album as a large vinyl record on top of the Forum in Inglewood, Calif., to kick-off the Eagles' six concerts and the grand reopening of the venue. Photograph: Forum/AP Photo Close

The Eagles’ multi-platinum "Hotel California" album as a large vinyl record on top of... Read More

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The Eagles’ multi-platinum "Hotel California" album as a large vinyl record on top of the Forum in Inglewood, Calif., to kick-off the Eagles' six concerts and the grand reopening of the venue. Photograph: Forum/AP Photo

A recent article by Tracy Alloway in the Financial Times turned heads when it compared exchange-traded funds to the Eagles song "Hotel California," in that investors can get in anytime they like but they can never leave. While using rock lyrics to explain the world of finance is fun to do, saying you can “never leave” an ETF is a stretch akin to Michael Lewis saying the entire stock market is “rigged.

Billions of dollars worth of ETF shares trade daily and account for about a quarter of all volume on the NYSE. Trading the vast majority of ETFs can be relatively easy regardless of market conditions. Alloway has a point with a small minority of days for a small minority of ETFs that track relatively illiquid markets.

Generally speaking, an ETF's only as liquid as its underlying holdings. If there's a huge selloff in a market of less liquid securities the ETF will follow suit and trade lower than its stated net asset value (NAV), or the value of its underlying portfolio. In many cases, the lower price is partially due to the NAV being stale and not yet including market-moving news. For example, with emerging markets ETFs, the NAV will include overseas holdings traded on exchanges that have already closed. With junk bond ETFs the NAV may include some bonds that haven't traded in days. Meanwhile, the ETF is trading real-time as news breaks, which is why BlackRock has argued that the discounted ETF price is the “true market,” and that it's the NAV that has to catch up.

Even on these rare stressful occasions, you can still sell the ETF. You'll get less than you’d want, though, since the firms that step in to make liquid markets for the ETFs have more difficulty pricing, hedging and arbitraging the underlying securities. This is why selling an ETF on Hotel California-type days is arguably the worst thing you can do.

Look at the example of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which tracks relatively illiquid junk bonds -- 90 percent of which don’t trade every day. In the taper tantrum of mid-2013, when interest rates rose 1 percent over 43 trading days, HYG closed at discounts on 20 days. It also closed at premiums on 23 days. On June 19 -- one of the worst days -- it closed 0.91 percent below its net asset value. The ETF bounced back the next day and closed at a 0.34 percent discount. A few days later it began closing at small premiums.

When it comes to liquidity, ETFs are like rubber bands. Their prices may stretch away from the NAV due to sharp drops in underlying holdings, but they snap back. Over 20 years, ETFs have lived through the Internet bubble bursting, the 2008 financial crisis, the flash crash and plenty of other bad days and every time they bounce back pretty quickly.

The larger point for buy-and-hold investors to consider is that despite those rough days, HYG’s three-year return is 25.4 percent. That nearly nails the 25.8 percent return of the index it tracks. It yields 5.8 percent and charges 0.50 percent of assets on an annual basis. That's all you can ask of a junk bond ETF, especially compared with trying to buy and sell a basket of high-yield bonds yourself, or using a high-priced mutual fund. Vanguard has a high-yield corporate index fund that charges 0.23 percent, but has trailed its index's return by 2.6 percent over three years.

A good rule of thumb: The more exotic an ETF's underlying holdings the more you'll see premiums and discounts form in times of market stress. Alloway says ETFs promise a “never-ending stream of liquidity” but it isn't clear who's making that claim or what advertisements are using that phrase. ETFs can only promise convenient, low-cost exposure to just about every investment under the sun, but they're not magic. Investors who wouldn't normally invest in junk bonds or Nigerian stocks probably shouldn't invest in ETFs tracking those areas.

More stories from Eric Balchunas:

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Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here, and weekly ETF podcasts can be found here.

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