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Converting Stone to Water!

So an Exchange Traded Fund is listed to trade only to provide the opportunity to sell (as well as buy) the fund. This liquidity makes the fund more attractive to investors. An investor does not have to deal with the Fund Administrator / Manager. It can simply sell the units or shares of the funds in the stock exchange.

Liquidity is a great thing for investors! But what about the liquidity of what the Fund contains? The places where the Fund has invested: are those things sale-able? The usual ETFs invest in gold and indexes which have high sale-ability – liquidity.

The sense of freedom that an ETF creates owing to the listing, hides the risk that not everything it contains is necessarily sale-able. A real-estate developer who has a large stock of unsold properties can bundle them into an ETF. Investors who buy the ETF are buying those same properties which they are refused to buy from the developer! Everyone feels happy- but mostly the developer, who finally managed to convert his unsold projects to cash.

So, it is important to know what goes into the ETF.

A more exotic category of investments that can be used in an ETF structure are leveraged loans. These are usually low-grade loans. Investors in “leveraged loan ETFs” are investing in loans that they might not like to make a direct investment in!

And what happens to low-grade loans if there is any market downturn or economic distress? They fail first. But not the ETFs which hold them. ETFs fail only when investors want their cash back from the Fund itself.

When things go sour, the buyers on the exchange for that ETF will evaporate. The only place to go to get back cash is the Fund itself. But the real estate, the low-grade loans are unsaleable; illiquid; cannot be converted into cash that easily.

It happened famously in 2008: liquidity in the markets evaporate - for the bad stuff first and then later even for good stuff. There were no buyers left.

But it happened again in 2015, too: when Third Avenue's ETF "Focused Credit Fund" suddenly found no takers in the market. Public memory is short!

Now, in 2018 data has emerged that shows that leveraged-loans (read: low grade loans) are a trillion dollar market. And there is a large increase in the number of mutual funds and ETFs that invest in leveraged loans.

This is typical boom-time behavior. It is called pro-cyclicality. And sets up for a bust.

If you want to read more about the Third Avenue episode, go here:

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