Once little more than a twinkle in the eye of the investment industry, exchange traded funds (ETFs) have rapidly morphed into an unstoppable force, surging in popularity even amid the gravest market setbacks.
Having originated in the early 1990s, they now represent major market participants. The level of assets in ETFs and exchange traded products (ETPs) breached the $6tn threshold for the first time in 2019 (see chart below), with many individual ETFs now controlling billions in assets. But such clout is accompanied by a host of pressing questions, with industry observers levelling some serious charges against the products.
One important criticism centres on liquidity and the stability of prices. ETF shares are generally easy to buy and sell and, in most cases, should trade close to the net asset value (NAV) of the fund’s underlying investments. This price stability in part relates to the so-called arbitrage mechanism: if an ETF’s shares trade at a discount to NAV, market participants should be able to buy the shares cheap and separately sell its constituent parts at a higher price to make a risk-free profit.
But the European Systemic Risk Board (ESRB) has warned that this process can be imperfect, with no incentive for market participants or market makers to engage in the arbitrage process. Any breakdown of arbitrage could result in price swings on ETF shares and further volatility. Separately, some might ask whether ETF liquidity can hold up in the face of extreme trading volumes.
ETFs also stand accused of potentially exacerbating market volatility. If so much money sits in products that are easy to trade, critics fear it could trigger a wave of selling that engulfs the market at points of stress.
The ESRB adds that assets held in ETFs may also be subject to greater volatility because the high liquidity and continuous trading of their shares “enables investors, including noise traders, to take large short-term directional positions on entire asset baskets”. DB
Have questions on structure been answered in the sell-off?
Undoubtedly, the ETF industry has made it possible for investors to implement low-cost and tax-efficient strategies, and for that it should be commended. Portfolio diversification is now simple, as ETFs are perfect building blocks to achieve your desired asset allocation. Net inflows of nearly $66bn in 2020 so far (ETFGI Research) shows their popularity hasn’t waned during the Covid-19 pandemic.
The products provide a highly liquid secondary market, making it easy to adjust positions in primary assets that are less easy to trade. In normal market conditions, this was always a plus and, now we have seen a major episode of market distress in March 2020, spokespeople for ETFs can point to the fact that trading continued to function.
Rapid, colossal intervention by the US Federal Reserve was what put a brake on the sell-off in asset markets. So a cautious appraisal of ETF shares’ performance in March would be to say that they respond to gargantuan stimulus as well as any other listed security.
More critical observers might also ask searching questions about the underlying product structure of ETFs and, if the Fed hadn’t taken unprecedented action, whether an unwinding was on the cards. Due to the market mechanisms ETFs rely on, it’s not unreasonable to postulate they contribute to systemic risks that turbo-charged the central bank’s response.
Overwhelmingly, market activity involving ETFs is the secondary market trading of ETF shares, which has been a revelation for asset managers and retail investors alike in building cost-effective portfolios. Market makers help make a bid-to-offer spread for ETF shares in the same way they would for any publicly traded security. Most buy and sell side demand can be met from existing ETF shares, and stock exchanges pool market makers and other sources of liquidity to match orders.
The ETFs can track the value of assets throughout the trading day and give accurate price discovery, all thanks to how their open-ended fund structure works at the fringes. When there are more buyers than sellers of ETF shares, or vice versa, then rather than the ETF shares trading at a premium or a discount to the underlying asset, they are created or redeemed.
This process, often described as the secret sauce that makes ETFs work, is possible thanks to the relationship between ETF issuers and authorised participants (APs), who are mostly market makers or large investment banks.
When there is strong demand for a fund, an AP will buy baskets of underlying securities to replicate the index the fund tracks and exchange them for new ETF shares from the provider, which they can sell on the market. The redemption process works in reverse – the AP buys ETF shares on the market and exchanges them with the fund provider for underlying securities they can sell on.
In smoothly functioning markets, there is a natural arbitrage between the price of the underlying securities and the ETF shares, which works if they are being created or redeemed. This enables the APs to make a profit and it attracts enough of them to make the arbitrage disappear rapidly, ensuring very low tracking error between ETF shares and the NAV of the funds.
In a major sell-off, however, the fear was always that APs would step away from the market. There is no legal obligation for them to buy unwanted ETF shares, which could make the famed liquidity of the products dry up. After all, a rout of ordinary shares across the board means prices can move rapidly against the market makers, with a risk they could lose money on the securities they redeemed the ETF shares for.
Fortunately, this scenario didn’t come to pass in March. The Nasdaq and New York Stock Exchange have emergency market-wide circuit breakers (MWCB), which pause trading to allow participants to take a deep breath and not get caught in a downward spiral of panic selling.
Redemption of passive funds could in theory flood the market with forced sellers, adding impetus to the velocity of selling, but the extent to which this was to blame for the S&P 500 losing a third of its value in little under four weeks is pure conjecture. After all, there was the fear of a global pandemic and lockdown measures shredding all forward assumptions of company earnings.
In any case, had the APs refused to make a market for sellers of ETF shares, there would have been no mechanism for redemption – effectively like a mutual fund placing a gate on withdrawals – so limiting rather than adding to the number of underlying stocks being sold. True, this would have led to ETF shares at discounts to NAV, but that would only serve to tempt market makers back to the table.
As it happens, S&P 500 ETFs stayed tight to benchmark throughout March and naysayers are reduced to arguing the counterfactual when it comes to equity products. There remains a case to answer on the issue of capital allocation, however. Arguably the main reason that tech stocks have risen to account for a fifth of the S&P 500 market capitalisation, is simply because they have produced the best earnings performance and still have a clearer path to long-term revenue growth than many old industries.
Passive products reinforce rather than decide market weightings and, given the impetus to buying tech shares, their relative size compared to smaller companies would probably be no different if there was only trading in individual shares. Where there may be more of a problem is further down the market cap scale, but optimists can point to product developments such as environmental, social and governance (ESG) scores and factor-informed indexing, which have potential to reintroduce more granularity in deciding companies’ cost of capital.
When markets were volatile in the spring, there was evidence of anomalies in the fixed-income space. Thanks to the nature of the baskets of securities the bond ETFs track – a fund will typically buy sample bonds to represent the duration and credit quality of the fund mandate – there is more scope for anomalies in pricing. In other words, the bond ETF is more vulnerable to idiosyncrasies in the market of the underlying security.
Despite being a larger market, fixed-income ETFs lag their equity cousins in assets under management (AUM). It did raise eyebrows that the Federal Reserve used fixed-income ETFs as part of its bond buying programme and cynics might infer that the Fed was acting to sure up the products as part of its wider efforts to remove volatility from credit markets. This would be strenuously denied by the industry, and moving to the UK credit markets, the Bank of England’s interpretation of how bonds behaved in the first quarter of 2020 seems to absolve ETFs of blame. JN
Explaining anomalies: what did the behaviour of fixed-income ETFs tell us?
While equity ETFs showed no obvious signs of stress amid this year’s sell-off, the picture looked vastly different in the bond space. In March, some of the biggest corporate bond ETFs’ shares traded at discounts of more than 5 per cent to net asset value (NAV), having not exceeded discounts of 0.1 per cent in January.
Investors wishing to raise cash in the teeth of a crisis may well have balked at the prospect of such deep discounts. But the official explanation asserts that the problems lie with the underlying fixed-income market and how it arrives at prices, rather than ETFs, which appear to have worked as a price discovery tool and a pressure valve for an illiquid market.
The Investment Association (IA), the trade body for asset managers, draws a stark contrast between the underlying bond market and bond ETFs in a policy briefing on the subject. It notes that price discovery for fixed-income securities can be difficult because the bond market itself is fragmented and not standardised, with no closing auction period. Bonds are traded over the counter (OTC), or via a network of dealers and brokers, rather than on an exchange.
As such, the NAVs for underlying holdings that ETFs (and open-ended bond funds) refer to are often based on a theoretical bond price that is “indicative, reasonably estimated and as close as possible to a fair value”. The theoretical price might not be what a bond actually trades for, especially in times of stress when valuations are fluctuating rapidly.
Accounts suggest enormous volumes of bond ETF shares successfully changed hands in March, with exchanges allowing investors to buy and sell ETF shares without actually trading bonds. A white paper from Invesco, an ETF provider, states that US-listed bond ETFs traded a total of $738.8bn on exchange in March, with just $19.8bn redeemed in the primary bond market over the period. This means that $719bn of fixed-income ETF shares changed hands without a real bond actually being sold – a strong defence of ETF liquidity. High trading volumes also occurred on the back of market improvements: on 9 April, the day the US Federal Reserve announced additional stimulus plans, the iShares $ Corporate Bond UCITS ETF (LQDE) traded over nine times its average daily volume, according to figures provided to the IA.
Even with investors able to trade fixed-income ETF shares in bulk, the discounts on show may have seemed alarming. But the argument runs that the theoretical prices achieved in the underlying bond market were stale and unrealistic, while the prices on ETF shares reflected actual trading activity.
This view is not limited to ETF cheerleaders. The Bank of England, in its Interim Financial Stability Report for May, states that prices on bond ETFs “appear to have provided information about future changes in underlying asset markets, offering evidence that they incorporated new information more rapidly than the NAV of assets held within their, and equivalent, funds”. In its own assessment the Bank for International Settlements adds: “Compared with the relative staleness of bond prices and NAVs, ETF prices can be useful tools for market monitoring and valuable inputs to risk management models that require up-to-date assessments”.
As such, ETFs provided an element of price discovery that was lacking in the underlying market. It is also “entirely possible that the cash bond market would have collapsed” had ETFs not been around to relieve the selling pressure, Invesco argues.
The official argument also deals with claims that the arbitrage mechanism was found wanting. While some of the discounts looked steep at the time, the IA has argued that there was “no obvious arbitrage opportunity” because market participants agreed that the ETF prices were based on actual tradeable bond values.
By contrast, ETF shares trading at premiums or discounts to NAV can sometimes reflect other developments, such as when a UK-listed ETF trades at different hours to its underlying market (and misses some price movements). High transaction costs can also sometimes lead to slight premiums and discounts.
Invesco has argued that now is the time to focus on improving how bonds are priced. The asset manager notes that more over the counter (OTC) markets should have central reporting of trades and prices, with this data distributed to market participants with minimal delay. Pricing should also have more emphasis on traded prices rather than “stale” quotes. The events of March, they add, should provide “ammunition” for a change. DB
How ETFs fit in the evolving financial system
Change is the operative word and the financial system will certainly not be the same as the world battles back from the Covid-19 pandemic. Thanks to the last great crisis 12 years ago, many of the tools central banks have used to prevent contamination of commercial paper and credit markets were already familiar; negative real interest rates and quantitative easing (QE) almost feel normal now.
As well as unknowns, such as how bad coronavirus would be and what severity and duration of lockdown would be needed, the other factor that drove such a violent market sell-off in March was the breakdown of the US treasury market. This is far from solely attributable to ETFs, but the funds are part of a financial system that requires greater injections of liquidity by central banks to function.
There was already tremendous stress in the overnight bank lending repo market before the Covid-19 crisis, a problem that was exaggerated by the sell-off as positions unwound. This was due to several activities from the likes of hedge funds, which guzzled a huge amount of cash to meet margin calls on futures contracts used to protect the other side of their positions, so it wasn’t all down to ETF trading.
What’s worth noting, however, is the extent to which APs involved in ETF creation and redemption use futures contracts as part of their operations. In 2017, a paper by Rich Evans (University of Virginia), Rabih Moussawi, Mike Pagano and John Sedonov (Villanova University), highlighted the prominence of the APs both in terms of operational short-selling of securities and in failures to deliver underlying stock as part of those contracts.
Now, this isn’t to say the APs are doing anything wrong; they have dispensation as part of their bona fide market making activities, to fail to deliver stocks within the Security and Exchange Commission’s usual deadline. This is not only legitimate; adding days to the settlement timeline can improve liquidity in the underlying securities held by an ETF.
The report’s writers described the overall process as having benefits at the micro level of an individual ETF, but possibly it was negative at the macro level of the overall financial market due to increased counterparty risk.
They also explain that an AP in ETF markets has an incentive to behave in this way as they can profit from buy-sell trade imbalances with a combination of derivative contracts and using the extended settlement period to wait for order imbalances to mean revert. They then use existing secondary market ETF shares to cover positions, which is cheaper than trading in the underlying securities to create and redeem creation units.
One thing the ETF industry has always stressed is that, for all their success, they only represent a fraction of US equity market capitalisation. All US equity ETFs have a combined value of $3.16tn, whereas just the S&P 500 index of the largest US companies is worth $27.696tn.
Furthermore, the creation and redemption process involving turnover in underlying securities is a relatively small part of ETF-associated trading. This ignores their hidden impact, however. At the time of the report, three years ago, ETFs already accounted for over 20 per cent of short interest and nearly 79 per cent of failures to deliver in US equities.
The other activity that ETF managers engage in – and it is common practice by mutual funds too – that has always been viewed suspiciously is stock lending. Asset managers have vast pools of securities sat on their books, so lending them out to counterparties provides a lucrative source of revenue. With $6tn in AUM, it’s unsurprising the ETF providers have looked to take advantage, but with derivatives already widespread in other aspects of the industry, it all adds to complexity and the need for ever more liquidity.
Overall, the financial leverage of market makers engaged in such trades is a potential source of systemic risk, which is why ensuring they have access to funding lines is crucial. That means dollars, which the Fed can inject into the system by buying US Treasuries. The central bank’s intervention is crucial, as a breakdown in demand for US Treasuries in March made the bonds less liquid, undermining the owners’ ability to sell them to raise cash to meet margin calls.
Globally fixed-income ETFs have $1.266tn AUM – that includes all bonds, so they are too small to be driving the structural trends that caused a breakdown in the US Treasury market. However, the products may have a role in some market quirks – after all, passively buying certain issues of bonds jogs memories of investment partnership Long Term Capital Management at the turn of the millennium. Its demise and the shockwaves it sent through markets was due to algorithmic trading creating demand only for freshly issued ‘on-the-run’ bonds, which made issues with just a few months’ less maturity illiquid.
So, some idiosyncrasies of ETF products might not help, but there are a multitude of other factors that contribute to the fragility of asset markets. The root cause of them all being a decade of excessively cheap interest rates, which allowed bonds and equities to get so expensive – and therefore vulnerable to a black swan event such as coronavirus. JN
