Exchange Thoughts - ETFs and Volatility: Weathering the Storm

How has the ETF structure held up against historic volatility? In short: exactly as designed.

One of the lessons of the recent wild ride in equity and bond markets is that both retail and institutional investors are increasingly relying on exchange-traded funds (ETFs) to implement their investment responses to the crisis. This has caused record levels of inflows and outflows in some of the largest funds, especially fixed-income ETFs that traded at unusual discounts to their net asset values (NAV) until the US Federal Reserve stepped in to stabilize the market.

An illustration of how crucial ETFs have become to market players: even though equity markets have lost $26 trillion in value since mid-February in the coronavirus-related selloff, some ETFs have experienced historic inflows as well as outflows. In fact, during the start of the crisis in February, US ETFs had $21 billion in net inflows, despite the market shock.1

Big inflows as well as outflows

The State Street Global Advisors SPDR S&P 500 ETF (SPY), which has $226 billion in assets, saw an average of $85 billion in trades during a one-week period in March and took in an additional $7.5 billion in a single day's trading on March 16, a day when the S&P 500 index itself was down 12%.2 Some analysts said the inflow was due largely to investors needing the ETF to cover their shorts of the overall market.

On the other hand, bond funds recorded substantial outflows. As we described in our 2020 ETF Survey, for the first time, bond funds attracted more new money in 2019 than equity funds, exceeding the $1 trillion asset threshold. But investors' belief that the bond funds would shield them from a market downturn proved somewhat illusory, with such staples as BlackRock's iShares Core US Aggregate Bond ETF (AGG), losing $3.1 billion, the largest amount ever since it started trading in 2003.3

Bond funds hit by liquidity crunch

Bond funds of all stripes faced an unprecedented liquidity squeeze due to bond markets drying up, which resulted in spreads widening and many fixed income ETFs trading at sizeable discounts to the NAV of their underlying assets. These dislocations are usually arbitraged away by market makers, but this has become more challenging without liquidity in the underlying bonds. This shouldn’t be viewed as a technical issue within the ETF wrapper, but more of a function of how the bond markets operate. ETFs are continuing to act as a real-time price discovery tool while many of the bond valuations in the NAV are evaluated prices or fair valuations that are updated once a day.

But on March 23, the fortunes of many of those bond ETFs reversed as the Fed introduced what it called the Secondary Market Corporate Credit Facility, an unprecedented step (among many adopted in the past few weeks) which committed the central bank to buy corporate bonds and corporate bond ETFs for the first time. This puts the Fed into a position of a de-facto ETF market maker, ensuring sellers of certain corporate bond ETFs will have a willing buyer on the other side of the trade. This is clear acknowledgement that the Fed recognizes the importance bond ETFs now play in the market.

Fed will buy ETFs as well as bonds

The Fed said it will buy US-listed bond ETFs whose investment objective “is to provide broad exposure to the market for US investment grade corporate bonds.” It can buy up to 20% of an ETF's shares. The market reaction was immediate: One of the largest investment grade corporate bond ETF, which had traded at a 5% discount to its NAV in the week before, began trading at a 1% premium.

The Fed's action recalled the efforts of the Bank of Japan (BoJ), which has purchased $250 billion in Japanese equity ETFs, becoming the single largest ETF investor in the market and now owning nearly 8 percent of all Japanese shares.4 But since equities are traded on exchanges, there has been few liquidity problems involving equity ETFs, so the Fed has little need to start buying equity ETFs as the BoJ has been doing for several years.

Before the Fed's move, many issuers of fixed income ETFs implemented changes to their platforms to make it more expensive for authorized participants (APs) to redeem ETF shares for cash. This is an effort to try to steer the APs to take a basket of securities from the fund rather than the fund trying to sell securities in a volatile market to raise cash for a redemption (and maintain some tax efficiency).

For example, one large ETF issuer said it would charge two percentage points on cash redemptions in one of its core bond ETFs, an increase from 50 basis points. Another prominent issuer also added 2 percentage point surcharges on cash redemptions to a similar vehicle, but those surcharges were cut when the market stabilized.5

New ETF issuance may pick up after lull

The recent market turmoil has raised questions around the launch dates of the more differentiated ETFs that had been in the works before the market rout. For instance, last year, the Securities and Exchange Commission (SEC) granted conditional approval to a number of proposed semi-transparent funds that would mask the manager's investment strategy by not fully disclosing the underlying assets on a daily basis. But they had not come to market before the crisis — until now. As of April 2, the first actively managed, non-transparent ETF started trading on secondary exchanges. BBH expects to see more list this quarter.

It also appears some of this market volatility may present opportunities for managers as more nuanced types of ETFs have been enjoying time in the limelight. For example, a thematic fintech ETF, which tracks financial technology products, mobile payments, peer-to-peer lending, and digital currencies, has seen volume pick up dramatically in recent weeks. So too have “buffer” ETFs which aim to shield investor losses – three such ETFs launched in March. And Esoterica Capital, a new ETF issuer, recently launched an actively managed fund that targets companies involved in fifth-generation digital cellular network technology (5G).

1, ETF Inflow Positive Despite Virus, March 2, 2020.
2 Morningstar, March 2020
3, March 2020
4 ETF Stream, Tackling the Bank of Japan’s ETF dilemma, February 17, 2020.
5 Wall Street Journal, BlackRock, Vanguard Raise Price of Cash Redemption for Some ETFs, March 20, 2020

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