Monday’s guarantee by the Federal Reserve to buy unlimited US Treasury bonds and expand its asset purchase scheme saw an initially muted reaction from stock markets but, following agreement of a $2trn fiscal stimulus package by Congress, the S&P 500 ended up over 9 per cent on Tuesday. This strong move demonstrates a widespread belief that the economic remedy to this crisis requires government spending as well as monetary policy but, with coronavirus still on the rampage and US cases surging, markets will remain volatile.
Printing money won’t cure coronavirus and if people and firms aren’t free to go about their business, demand and supply in the economy will contract regardless. What quantitative easing does do, however, is provide desperately needed support for the financial system.
The role of exchange traded funds (ETFs) is controversial, but providers have long argued the ease of buying and selling shares in the open-ended funds aids market participants. In effect this secondary market represents an additional layer of liquidity to the primary market in the assets the funds track.
Yet, it was always feared that when markets faced serious downward pressure, a mass exodus from passive index funds would add to selling velocity. Although much ETF trading is on the secondary market, shares in the funds must be redeemed when there are more sellers than buyers, which places strain on the liquidity of trading in the underlying assets.
The situation has been particularly acute with fixed income ETFs. “ETFs have been sucking up street liquidity as [it is] algorithmic selling and everyone can see them coming”, says Phil Milburn, co-Manager of Liontrust Global Fixed Income.
Creation and redemption depend on authorised participants (APs), who exchange underlying securities with product issuers for ETF shares, making a profit from arbitrage. In theory, this attracts enough APs that the arbitrage rapidly disappears, and the price of ETF shares closely tracks the net asset value (NAV) of their benchmark index.
This hasn’t been the case with important fixed income ETFs. Bloomberg reported last Friday that over 70 bond ETFs were trading at discounts of more than 5 per cent to benchmark NAV levels. The problem stems from being forced sellers and because fixed income ETFs tend to hold representative baskets of bonds, rather than buying every security in an index.
Corporate bonds have sold off during the Covid-19 crisis and it is the larger and most liquid bonds which move first. Hedging positions to buy and sell the less liquid bonds causes difficulties for APs and the discount to NAV has opened, largely reflecting their risk. While ETF providers can argue that the products facilitate exiting credit holdings in a difficult market, investors are in effect paying a hefty exit fee, the way they would for pulling money from some active funds.
The Federal Reserve stepping in as a buyer of corporate bonds in its expanded quantitative easing (QE) programme should alleviate concerns about the underlying liquidity of the market. Pumping cash into the system also helps with the complex trading positions needed for APs to hedge trades and make the ETF market work.
Funds that track equity indices, such as the S&P 500, have shown remarkably low tracking error in the sell-off, allaying fears that market makers would just sit on the side lines as buyers disappeared and the market was flooded with stock inventory from unwinding positions. The major US stock exchanges appear to have learned from flash crashes in the 2010s and the introduction of market circuit breakers (that have paused some trading sessions) has helped stem more savage selling.
European bourses were ahead of the curve on such innovation, but the US caught up quickly, explains HanETF Co-CEO and founder Hector McNeil. “Exchanges have tightened up a lot after the flash crashes, the circuit breakers make things more stable”. He adds that, “the market infrastructure is much more geared to take big drops or big rises, like are happening at the moment.”
Market makers and other APs rely on hedging positions for their role to function effectively. Being long/short stock futures and correspondingly short/long ETF shares requires cash to make margin calls and lubricate both sides of the trade. The industry is hardly alone in being thirsty for dollars but as it has become systemically important, starting 2020 with $6.35trn in assets globally, its smooth functioning is crucial.
ETFs are certainly not the villain of the piece. This week, the Financial Times reported that the funds themselves have been used to hedge equity trades, but it is in the context of supporting dollar intensive market activities that the Fed’s intervention must be viewed. This isn’t pushing on a string to stimulate growth: it’s trying to avert a credit crisis on top of the economic and humanitarian disaster Covid-19 has caused.
