Exchange-traded funds (ETFs) were widely criticised for failing in key ways as markets plunged in the coronavirus crash.
With investors scrambling for the exit in March in particular, wide discounts opened up between the prices of some ETFs and the value of their underlying holdings.
Headline-grabbing examples included one of the world’s largest ETFs, the Vanguard Total Bond Market ETF, whose shares traded at a 6.2% discount to its net asset value (NAV) in March, as investors pulled $34bn out of passive fixed income in the first three weeks of that month alone.
Critics claimed this showed that the liquidity ETFs profess to have was purely an illusion. But it would seem that the detractors misinterpret both liquidity and why discounts can quite legitimately emerge between the price and net asset value of an ETF.
The benefit of ETFs is that they offer intra-day trading and are priced continuously.
That isn’t always true for the underlying holdings, meaning the price of an ETF is often more up-to-date than the price of all the securities it holds. So at a time when markets were falling, the nominal discounts widened because the NAV no longer reflected market conditions.
ETFs have now become, in effect, the price discovery mechanism, communicating investor views on a basket of securities before that basket has formally repriced.
This is particularly the case with fixed income, an area where discounts widened sizeably at the time of peak market stress.
Bond trading takes place via archaic ‘over the counter’ process, which means bond prices are often out-of-date or difficult to quickly ascertain – especially compared to equities. In a fast market, this exacerbates discrepancies between fixed income ETFs and their underlying holdings.
Whether the price disparity is justified depends on whether the NAV ultimately follows the discount down, or whether the ETF discount simply narrows relative to stable bond prices. This can only be seen after the fact and so could be an area ripe for research.
The phenomenon is not confined solely to fixed income. It also features in the likes of emerging market equities, where underlying securities are less liquid and listed on different markets around the world with varying degrees of pricing efficiency.
In an extreme example, a US-based Philippine equity ETF never actually trades when the underlying market is open because of the 12-hour time difference.
It’s in the numbers
By way of example, the London Stock Exchange handled 1.3 million exchange-traded funds, commodities, and notes trades in March, equivalent to £50.9bn.
This compared to 713,000 (£29.8bn) in February and 430,372 (£17.4m) in March 2019. This suggests that there was no issue with liquidity and that many investors must have felt prices represented fair value.
Essentially, as markets became wilder, investors found that they could still trade ETFs and could do so at a reasonable price in many cases.
Like any other security, bid-offer spreads on ETFs widened in March, but data from iShares suggests that reasonable spreads were available throughout.
For the largest and most liquid iShares equity ETFs, the bid-offer averaged 7.5 basis points between February 24 and March 23, when markets fell their hardest, while for the iShares 20+ Year Treasury Bond ETF they fluctuated between one to eight basis points (as compared with up to 91 basis points for long-dated Treasury bonds).
Spreads did not blow out because the market makers competed to keep them tight. Their access to daily creation and redemption mechanisms mitigated their risk and enabled them to keep prices close to the underlying holdings.
It would be foolish to suggest ETF pricing is perfect, but the products have undoubtedly stood up to their first bear market as a truly mainstream asset class (something they arguably were not in 2008).
Whether you agree or disagree with the criticism in March, it’s certainly allowed investors to understand ETFs better. And that has to be a good thing.
Mark Northway is an investment director at private office chair of the Shareholder Society and vintage aircraft enthusiast, pictured above with his Focke-Wulf