BoE Financial Stability Report finds ETFs source of information on underlying assets

Bank of England

The May Bank of England (BoE) Financial Stability Report has found that investors ‘may have found it easier to trade ETF shares’ in March.

The report comments that in contrast to open-ended funds, ETFs’ shares trade in secondary markets, often on exchanges. “As a result, they offer immediate liquidity at intra-day trading prices. During the period of market stress in March, unlike in some previous stress events, investors may have found it easier to trade ETF shares than the underlying assets held by the ETF, and trading volumes in ETF shares rose significantly.”

As an example, the BoE cites the largest ETFs referencing US investment-grade corporate bonds, and finds that daily trading volumes in March were more than three times their January 2020 average. 

The BoE writes: “In light of the relative liquidity in ETF shares compared to the corporate bond market, price discovery was often occurring via ETFs rather than their underlying assets.

“During this period, ETF prices appear to have provided information about future changes in underlying asset markets, offering evidence that ETF prices incorporated new information more rapidly than the net asset values (NAV) of assets held within their, and equivalent, funds (Aramonte and Avalos (2020)).”

There were some large differences between intra-day ETF prices and the measured end-of-day value of their assets. In mid-March, some of the largest ETFs in both the investment-grade and high-yield corporate bond segments recorded NAV discounts in excess of 5 per cent, having been no larger than 0.1 per cent in January, the BoE writes.

“The differentials between the prices of ETFs and their daily NAV may suggest that the NAVs of open-ended funds were sometimes not factoring in the latest information during volatile periods. Lower ETF prices — which more accurately reflected the liquidity and the cost of selling the underlying assets — could have been an indication of the extent of first-mover advantage that was available to investors in open-ended funds holding similar asset portfolios to those ETFs, as investors redeeming from open-ended funds early might receive the potentially higher NAV price.”

However, some funds in Europe, including in the UK, used swing pricing tools to adjust the price received by redeeming investors, particularly during the most volatile periods. 

The BoE writes that there is some evidence that swing pricing adjustments applied during March were high and this could have mitigated the first-mover advantage.

“The secondary market trading of ETFs means there is lower risk of a dynamic that incentivises the fire sales of their underlying assets. But some ETFs do pose other risks, as the FPC outlined in the July 2019 Report. For example, those ETFs that invest in less liquid assets while offering redemptions in cash can give rise to liquidity mismatch, and result in procyclical investor behaviour.”

The Bank writes that if ETF liquidity became impaired in a stress, this would pose risks to any market participants who were reliant on them for liquidity and price discovery.

ETF pricing also responded to market interventions by central banks according to the report. Discounts for investment-grade bond ETFs closed globally towards the end of March, as the US Federal Reserve announced it would purchase US investment-grade bonds and ETF shares.

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Beverly Chandler
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