ETFs in challenging times

The coronavirus outbreak has represented what is undoubtedly the sternest test for financial markets since 2008. But as well as a challenge, it has also provided an opportunity for financial instruments to demonstrate their resilience. A paper published today by the IA demonstrates how this has been the case for Exchange Traded Funds (ETFs).

ETFs are a type of investment fund which, unlike many open-ended funds, are listed on one or multiple global stock exchanges.

ETFs have grown in significance in the global fund market since their introduction just over 25 years ago, with ETFs’ AUM growing to over $6 trillion worldwide by the end of 2019. However, questions had previously been raised by regulators and commentators as to their performance and resilience during times of financial stress. Questions which were raised again when, like other products, ETFs encountered significant volatility during the early days of the crisis.

In particular concerns were raised about ETFs trading at a significant discount to Net Asset Value (NAV) during late March – in other words, ETFs were trading for significantly less than its constituent securities were, particularly fixed income ETFs.

However, further examination reveals that, rather than representing a breakdown of ETF pricing mechanisms, in actual fact ETFs were providing a key source of liquidity and price discovery.

How does this work?

A key feature of ETFs is that they offer both a primary and secondary market. In the primary market, special dealers known as ‘Authorised Participants’ (APs) help manage the creation and redemption of ETF shares and the related trading of underlying securities (such as bonds or shares). In the secondary market, investors can trade their ETFs on one or more global exchanges.

During the early weeks of the crisis, liquidity in many underlying securities (especially bonds) dried up significantly, to the point where they became very difficult to trade.

The price of these instruments however is based partly on the price at which that instrument last traded. If that instrument hasn’t traded in some time, the on-screen price may become ‘stale’ – essentially, it may not actually represent the price at which investors are willing to trade.

However, the ETF secondary market allows investors to trade ETFs without having to trade the (often very illiquid) underlying instruments. During the crisis there was a record level of ETF secondary market trading, as investors looked to find liquidity in a challenging environment. Moreover, they also provided a source of price discovery. It might be difficult to know the price of underlying bonds, but if you could trade an ETF containing those bonds you could better estimate their value.

In other words, the price of the ETF provided a better guide to the actual price of an underlying bond, then the often ‘stale’ on-screen price of the bond did – a dynamic that was noted by the Bank of England in its May Interim Financial Stability Report. And towards the end of March when bond prices finally caught up to ETF prices, discounting essentially disappeared.

It is right that regulators and all market participants continue to analyse performance and resilience and look for ways to improve the investment ecosystem. But it is also important that we look to address understandable, but sometimes misplaced concerns as in the case of ETFs. 

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