Part 5: Explosion in Asset-Liability Mismatched Fund Structures

Daniel Zwirn, Jim Kyung-Soo Liew and Ahmad Ajakh | Published in The Journal of Fixed Income, Fall 2019

Explosion in Asset-Liability Mismatched Fund Structures

Mutual funds and ETFs typically provide holders daily, or better, liquidity. It is important to remember that most corporate bonds trade OTC because this trait is a crucial component of the hidden risks that appear in market crisis periods.

Recall that OTC markets are not as liquid as stock markets. Moreover, when a financial crisis strikes, the OTC market for corporate bonds will completely vanish. That is, when a crisis occurs, no market-makers will be willing to take the other side of the trade and thus provide liquidity for the underlying constituents of the corporate mutual funds and ETFs. Effectively, the mutual fund and ETF holders will have no redemption ability.

Exhibit 18

ETF Outstanding Corporate Bond Holdings as a Percentage of Total Holdings

Exhibit18 - 2020-07-07

This significant mismatch in the liquidity of the underlying corporate bonds and the structures into which they have been packaged, namely mutual funds and ETFs, is underappreciated by retail investors and regulators. The regulators, who cannot foresee the variety of risks these investors are exposed to, given the complexities of the corporate bond OTC markets, are especially in the dark.

ETFs create a false sense of liquidity. One effective way to understand the structure of the bond market is to identify the entities that own that market. Exhibit 18 shows the evolution of the percentage of corporate bonds in the ETF space since 2001. The relative share of the ETF market in corporate bonds has gone from zero to 3% of the total debt, over $420 billion dollars as of December 2018. This is a significant increase and serves as strong evidence that retail investors are eager to invest in higher-yielding retail products. Retail investors naturally want their “yield cake,” but will they get to eat it too?

Retail investors have been eager to purchase fixed income ETF products, and Wall Street financial engineers have enthusiastically created a variety of products to meet this demand. Currently, the largest fixed income ETF is the iShares Core U.S. Aggregate Bond ETF (AGG) with $53.8B in assets. Fixed income ETFs are a small component of the total fixed income market. The total size of the fixed income ETFs is currently around $640 billion,16 amounting to less than 6% of the total corporate bond market (estimated around $9.2 trillion; SIFMA 2019). But the ETF market for fixed income products has been growing over time.

Stephanie Pomboy of MacroMavens concisely summed up the liquidity concern with ETFs when she said, “In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid. The upshot is that these vehicles are only liquid in one direction” (Forsyth 2019).

Mutual funds with daily liquidity are holding illiquid assets. As Exhibit 19 shows, the percentage of the total debt owned by mutual funds up until 2007 was stable at around 7%. During the credit crisis in 2008, that number decreased slightly to below 7%. Since then we see that the percentage of bonds over the past decade has doubled to more than 15% of holdings, reaching over $2 trillion dollars as of December 2018. As noted, in the wake of a credit crisis, when the market is in distress mode, it is very difficult to sell illiquid OTC assets. As many authors, including Gary Gorton, have pointed out, a financial crisis is simply equivalent to a lack of liquidity in the market. One cannot help but wonder how the mutual fund industry plans on responding to the sudden lack of liquidity for almost $2 trillion of corporate bond assets in distressed market conditions.

Exhibit 19

Mutual Funds % Ownership of Corporate Bonds

Exhibit19 - 2020-07-07

One particularly striking example of this lack-of-liquidity scenario and market-making was the freeze in some of the major UK commercial property funds that took place in 2016 (Williams and Evans 2016, 2017). First, it should be noted that investors in general, and in the wealth management industry in particular, are drawn to real estate investment assets. Their preference for real estate investments over fixed income investments may be due to the tangible, straightforward nature of the former versus the complexity of the latter.

Many of these open-ended funds offer daily liquidity. Given these characteristics, namely tangibility, ease of understanding value, and, most importantly, daily liquidity, it is not difficult to see why uninformed investors invest in such funds. The mismatch between the assets’ liquidity—that is, the underlying real estate properties—and the liquidity provided to investors, which in the following example was daily, we denote as an “asset-liability mismatch”. This mismatch has bleak financial consequences for the investor, as illustrated in the following.

In 2016, the Brexit vote in the United Kingdom triggered a series of redemptions in the UK property fund industry. Seven large vehicles, including names such as Standard Life, Aviva, and M&G, holding 15 billion GBP cumulatively, were forced to suspend redemptions. Investors, therefore, were startled to suddenly find that their daily liquidity window had completely vanished. As an article in the Financial Times pointed out, some analysts believed that “Open-ended funds only work on the way up... On the way down the promise of liquidity in an illiquid asset class failed in 2007 and is failing again only eight years post-Lehman Bros’ collapse” (Williams and Evans 2017).

Another analyst in the same article in the Financial Times stated that open-ended property funds have sold “snake oil” by guaranteeing liquidity to retail investors. History has taught us that an open-ended fund’s version of daily liquidity disappears in periods of financial crisis. That is, when investors are in sudden and desperate need of this promised daily liquidity, there is none to be found and no opportunity to redeem.

Hedge funds and other alternative vehicles have asset-liability mismatches. The hedge fund universe is often cited as having a considerable liquidity buffer on an aggregate level. But that only provides some comfort systemically. At the end of 2007, 39.8% of hedge funds had a one-year lockup period, and even three years after the crisis there was still $100 billion locked up (Williamson 2011). In 2013, 36.5% of hedge funds still had a one-year lockup period (Evestment 2013).

Even those liquid alternative funds, like GAM Investments, which impose no explicit liquidity constraints (and rather promise their investors daily liquidity) are nonetheless subject to serious liquidity risks. In July 2018, GAM stunned investors with the announcement that it had suspended bond manager Tim Haywood, head of its unconstrained absolute return bond strategy. This triggered a flood of redemption requests and forced the firm to freeze affected funds. Finally, they shut down the absolute return bond funds, and the CEO stepped down. At this steep cost to GAM’s investors, we can glean the valuable lesson that no hedge fund is truly liquid so long as it can neither control nor predict the future, particularly the future unethical behavior of its investment directors.

Another illustration of this lesson can be drawn from the Bear Stearns and BNP Paribas ABS fund debacles. When examining a financial crisis in hindsight, the first question that arises is: was there an event that served as the financial-crisis equivalent of patient zero? Many believe that the 2008 crisis was triggered in July 2017 when two of the Bear Stearns Asset Management hedge funds (Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund) sent a letter to their investors telling them that they had lost almost everything. That event, however, is now understood to have been a mere harbinger of the mass panic that was to ensue three weeks later when BNP Paribas Investment Partners temporarily suspended the calculation of NAV and subsequently suspended redemptions in two of their asset-backed securities funds. They ominously explained that their actions were due to “the complete evaporation of liquidity in certain market segments of the US securitization market [that] has made it impossible to value certain assets fairly” (BNP Paribas 2007).

Exhibit 20 shows weekly data in billions of dollars on the vertical axis, for the amount of asset-backed commercial paper outstanding; the blue line corresponds to the week of the BNP announcement. It is stunningly clear that the BNP announcement triggered a panicked selloff in the commercial paper market. If one cannot calculate NAV, which is essentially a fair valuation of an asset, then there is arguably no price at which one can sell the underlying assets and execute client redemptions. This is yet another example showing that a hedge fund can be deeply vulnerable to a lack of liquidity in the midst of a financial crisis.

Exhibit 20

Amount of Asset-Backed Commercial Paper Outstanding over Time

Exhibit20 - 2020-06-12

A note on shadow banking. Bill Gross, retired co-chief investment officer of PIMCO, popularized the belief that looser regulations for funds and ETFs compared with banks can lead to a liquidity problem. He has opined that “mutual funds, hedge funds and ETFs are part of a ‘shadow banking system’ where these modern ‘banks’ are not required to maintain reserves or even emergency levels of cash” (Straits Times 2015). The low reserves subsequently lead to a severe liquidity squeeze when a financial crisis suddenly erupts.

As we have previously noted, though history lends much support showing that markets are not static and evolve in cycles, there are researchers who are not convinced (Taleb 2010).17 Though forecasting the next economic downturn is beyond the scope of this article, we can predict with near certainty that when the next downturn occurs, there will be no buyers of the underlying corporate bonds that are being packaged into ETFs and mutual funds, as shown previously in Exhibits 18 and 19. Essentially, ETFs and mutual funds’ client redemption requests will not be met, and the retail holders of these products will be haunted by the “ghost market” of another financial crisis.


16 ETF states that there are currently 384 fixed income ETFs traded in the US markets. These ETFs comprise of bonds and preferred stock with total assets under management of + $600 billion. “Fixed Income ETF Channel,”

17 Taleb argues that our strong tendency to point to the evidence of a black swan crisis after the fact is a signature of the unpredictability of black swan crises.