Proponents of exchange-traded funds laud the flexibility of the ETF structure when it comes to investment strategies, but some less-communicated realities of ETFs still surprise investors when they rise to the surface during market volatility.
In a stressed market, long-term investors may not need to consider the core mechanics of an ETF unless they willingly choose to transact. During that time, they could find significant premiums or discounts of the ETF price to various representations of underlying value. These gaps tend to normalize when a market clears.
At the same time, for critical players in daily ETF liquidity — short-term traders, arbitrageurs and market-makers — the shifting price and availability of underlying assets are very real and the costs to hedge exposure can change at a moment's notice, often dramatically, forcing aberrations from typical trading spreads, premiums/discounts to net asset value and even squelch the availability of cash redemptions.
Over the last two months, secondary market investors sold rate-sensitive ETFs (and traditional funds) with longer durations en masse as 10-year Treasury rates rose to as high as 2.7% from 1.6%. According to IndexUniverse, ETFs with underlying duration above 3.5 years shed $10 billion in assets in the second quarter.
In less liquid areas of the bond market — high-yield corporate, emerging market and municipal securities — the selling pushed many ETF prices to atypical discounts to their closing NAV, the set price at which creations and redemptions with the fund are executed. Indeed, the move also led some to question the validity of indicated optimized portfolio value, published throughout the day to give an indication of fair value of an ETF.
These dislocations in late May and early June prompted iShares, a unit of New York-based BlackRock Inc., to disseminate an open letter to investors on June 29. In the letter, Mark Wiedman, global head of iShares, offered up a contentious declaration: “More and more, ETFs are becoming the true market.”
The letter was a response to criticism — not directed only at iShares — that ETFs were breaking and failing to deliver on their stated goals of replicating an underlying index. But Mr. Wiedman's letter continued: “In a rapidly moving market, the reported prices of individual underlying assets may become stale. The ETF price can become the true price for that market, and the underlying assets may eventually catch up with any gap between the two.”
“Premiums and discounts offer a real expectation for the value of the fund,” says Chris Hempstead, head of ETF execution services at New York-based broker WallachBeth Capital LLC. “When trading spreads blow out in stressed markets, they hit thinly traded asset classes first and the ETF goes in to price discovery mode.”
Mr. Hempstead says that trading spreads widened in ETFs tracking emerging market debt and high-yield securities, for example, which was probably unsettling to investors comfortable with the prior spread range. “In volatile markets, the bid represents fair value,” he says.