ETFs and a Tin of Soup!

    Jason Xavier

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    In these times of heightened market volatility, exchange-traded funds (ETFs) have delivered on the main attributes that attract investors to utilising the wrapper—liquidity, transparency and cost efficiency—according to our Head of EMEA ETF Capital Markets Jason Xavier. He explores the subject a bit further and dispels some of the recent comments directed towards fixed income ETFs in particular, which he says is inaccurate.

    A tin of soup is a tin of soup! 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 utilising 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 utilise 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)1 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 makers2 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 clients 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 ETFs 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 penalised by new investor flows. Additionally, the executable transparency for incoming/outgoing investors is always preserved, even while underlying markets are experiencing times of stress.

    What Are the Risks?

    All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

    1. Net Asset Value (NAV) represents an ETF’s per-share-value. The NAV per share is determined by dividing the total NAV of the fund by the number of shares outstanding.

    2. A market maker is a firm or individual who facilitates liquidity by standing ready to buy or sell a particular security throughout a trading session.