Market gyrations illustrate resilience of the ETF market

"It's not a bug. It's a feature."

This aphorism, largely used to describe peculiar computer programming outcomes, should be emblazoned on the banner of the exchange-traded fund industry during times of market volatility.

As asset prices sank and capital markets gyrated over the past few weeks, several truths about the ETF market were reinforced as products were tested across the board. Somewhat fortuitously, ETFs have endured a series of challenges since the financial crisis that fortified them: the flash crash of May 6, 2010, municipal bond ETF discounts in 2013 and another flash crash on Aug. 24, 2015. On the other side of each of these scenarios, ETF investors, traders, regulators and exchanges emerged with a better understanding of how the products should price and trade.

While the recently volatility isn't ETF-specific, ETF trading surged to a record $1.4 trillion in the second week of March, according to BlackRock Inc., and accounted for 38% of all U.S. trading activity on stock exchanges from Feb. 24 to March 13. These moves have shined a spotlight on several features of the ETF market.

While the ultimate conceit of the ETF market is that the same product can be used by every type of investor and trader, the current reality is that a dichotomy exists between those preferred by traders and those used by more long-term investors. "Funds have personalities," said Elisabeth Kashner, director of ETF research at FactSet Research Systems Inc. Ms. Kashner analyzed the top 20 ETFs by assets under management and trading volume, separately. For both datasets, weighted by AUM or volume, trading spreads prior to the recent volatility were about 1 basis point. On March 12, when the S&P 500 dropped nearly 10%, volume-weighted spreads doubled to 2 basis points, while asset-weighted spreads expanded sixfold.

"It's much harder to steal liquidity compared to assets," said Eric Balchunas, senior ETF analyst at Bloomberg LP. The most liquid products primarily have robust derivative markets that give market makers more leeway to lay off risk, whereas products that are primarily marketed to long-term holders, such as those offered by Vanguard Group or Charles Schwab, tend to track indexes with less robust futures and options trading.

"When there's market dislocation, ETFs become a tool for price discovery," said Dave Nadig, chief investment officer and director of research at ETF Trends. "We shouldn't have to learn this every time."

For example, the price of the Vanguard Total Bond Market ETF closed at a 1.4% discount to net asset value on March 13, after spending nearly 93% of 2019 at a discount of zero to 25 basis points. Such a large move in the discount to NAV highlights the challenge for a fast-moving market in pricing and trading fixed-income securities beyond (and sometimes including) Treasuries.

For high-yield corporate and municipal bond ETFs, the dislocation was even greater. Discounts to NAV for the two largest junk bond funds from BlackRock and State Street Global Advisors moved beyond their consistent range of roughly (+/-) 50 basis points while the VanEck Vectors Municipal High-Yield Index ETF moved to a nearly 12% discount.

Such directional signaling is not unique to fixed-income products. For ETFs holding international equities, U.S. intraday trading after the stock's home market has closed can serve as an indicator for individual securities when they reopen the next day.

While prices and trading discounts to NAV are the domain of the primary and secondary markets, most ETF portfolio managers are more or less insulated from the volatility.

"Our job is to be a fiduciary and steward of client assets and stick to our investment objectives," said Dan Draper, managing director and global head of ETFs at Invesco Ltd., which manages the $82 billion QQQ fund.

"Our capital markets teams are constantly in touch with our portfolio managers, but when there is heightened activity and high volume, they are paying particular attention on rebalancing and risk management."

One challenge that could arise from such a rapid decline in assets under management — even as many ETFs still experienced positive net flows in the past few weeks — is that smaller managers that might have used fee waivers to compete on price may have challenges keeping products (or even themselves) open.

"Size and scale matters," said Mr. Draper, whose firm is the fourth-largest ETF issuer in the United States.