ETFs delivered during heightened market volatility

May 12th, 2020 | By | Category: ETF and Index News

By Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

For years, ETF practitioners like myself, my colleagues, and industry counterparts have often said, “ETFs do what they say on the tin!”

The attributes of ETFs include liquidity, transparency, and cost-efficiency. Over the years, our team has suggested investors consider complementing their portfolio construction with either a core or tactical allocation to utilizing the ETF wrapper.

In our view, the events of the last two months, and the continued dislocations and volatility in the underlying market caused by the Covid-19 pandemic, point to an ever-more pressing case to utilize ETFs for all of the above-mentioned benefits, in particular, the liquidity and transparency in heightened volatile periods.

At the height of the recent coronavirus-driven volatility, some critics suggested that ETFs—in particular fixed income ETFs—were causing dislocations in the bond market, and many fixed income ETFs were wrongfully trading at a discount to the net asset value (NAV) of those respective funds.

To fully appreciate why this is an inaccurate assessment, it’s worth taking a step back and appreciating the different market microstructures between fixed income (bonds) and equity securities (stocks).

Trading in the bond market is still driven primarily by the over-the-counter (OTC) market—where parties trade directly, off-exchange. In extremely volatile periods, fixed income ETFs (which do trade on exchange) may sometimes trade away from the NAV of their underlying index. This is because the NAVs are often calculated based on delayed prices, not on real-time executable prices, which ETF market makers can take action on.

However, what we have seen in reality during this recent period of turmoil is that fixed income ETFs have actually given investors actionable price discovery and on-exchange transparent pricing within the traditionally OTC-driven asset class, and it’s clear that many now appreciate how ETFs are intended to work. While some commentators have tried to suggest the recent market turmoil has exposed an issue with the wrapper, we’d like to highlight how it actually cements the fact that “ETFs do what they say on the tin”.

Let’s take the scenario just mentioned of a fixed income ETF trading intraday at a discount to the ETF’s NAV. Firstly, the accurate intra-day pricing illustrates the intraday liquidity the ETF wrapper offers. While we have seen markets down percentages intraday, the ability to take a trading action of a fund holding in real-time illustrates the ETF’s ability for a valuable tool in liquidity management.

The second component is transparency. While ETFs are transparent via daily holdings disclosures, this scenario also points to transparency around execution. As highlighted earlier, the ability for ETFs to be mark-to-market intraday, and for ETF market makers to accurately price the underlying basket and offer accurate bid/offer (buy and sell) prices in real-time, gives investors full transparency around their cost for execution, and in volatile times, the extra cost for the same execution.

The third attribute is cost-efficiency. Again, while the efficiency of the ETF wrapper helps keep total expense ratios to a minimum, this scenario also points to cost efficiency for all types of investors—whether they want to direct assets toward a new ETF investment, sell out of an existing one, or maintain their current portfolio.

As we’ve outlined, the ETF’s ability to accurately price the underlying basket ensures incoming/outgoing investors accurately pay for entering/exiting a fund independently. As a result, ETFs keep costs independent and fully transparent, helping to ensure existing shareholders are not penalized by new investor flows. Additionally, the executable transparency for incoming/outgoing investors is always preserved, even while underlying markets are experiencing times of stress.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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