Rumi Mahmood, head of ETF research, Nutmeg, shares his thoughts on how ETFs behaved during the market crisis of early 2020
We’ve long held the view that in the next market downturn, somewhere down the line ETFs would be vilified. And that happened, initially, with headlines noting: wild swings in premiums/discounts; illusion of liquidity; exacerbating volatility. But after the initial hysteria and alarmist headlines, as calmer heads prevailed and market participants shared their truths, the tune changed, and ETFs emerged as a hero in troublesome times.
In the recent downturn, investors turned to ETFs for price discovery and to exchange risk while underlying markets were impaired. The structure of the ETF ecosystem enables trading to take place in the secondary market without execution of the underlying securities, thus enhancing overall ETF liquidity. This proved vital in this downturn, as ETF trading as a share of market volume skyrocketed. From a 2019 average of 28 per cent, ETF trading as a share of market volume rose to a peak of over 40 per cent in March 2020 (Bloomberg).
A number of reports has been published since then by the Bank of International Settlements, The Bank of England and The Investment Association among others, highlighting the role ETFs played and commending the transparency in these products. In particular in fixed income, which has proven valuable to investors – both active and passive – in providing a window into markets, helping to establish real-time, tradeable prices.
Some concerns were raised initially on fixed income funds exhibiting dislocations between price and NAV, however it quickly became apparent that ETF prices were reflecting truer real-time pricing versus slower moving NAV estimates by fund administrators.
Comments included: “price discovery was often occurring via ETFs rather than their underlying assets” – BoE
“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” - BIS
“ETFs were providing real-time pricing and were far more liquid than the underlying bonds” - IA
Published testimony aside, central bank acknowledgement of their role, and the Fed’s inclusion of ETFs in their asset purchase programme further signifies their function as a release valve. The illusion of liquidity was dispelled, with magnitudes of difference between the liquidity between the underlying asset and that of the ETF. As an example, in March the largest high yield ETF in the US traded on average 170,000 times a day whereas the top underlying bonds traded on average 25 times a day (Bloomberg).
From our experience at Nutmeg, we were able to trade in strained asset classes such as corporate and high yield bonds, in large size at spreads we would consider reasonable given the prevalent volatility. What has always remained true is that ETFs provide the ability to trade, whereas that is not always possible in the underlying or a mutual fund structure without a secondary market. One may not always like the price in the backdrop of market volatility, but it’s good to have the option to trade, without risk of being gated.
A commonly stated reason behind ETF scepticism is their rapid rise. This is natural, any financial product that grows fast deserves scrutiny and analysis with evolving regulation to ensure it behaves the way it is supposed to and reflect the underlying asset class. This has certainly been the case with ETFs.
The fact of the matter remains that when the going got tough, ETFs got traded. Fundamentally because they behaved as a risk transfer tool, because they have a secondary market. Because it’s possible to equitise them, lend them, they have derivatives making it easy to hedge them, with more liquid reasons to point. ETFs have had their resilience tested and fundamental misunderstandings have been debunked.