As asset prices plummeted and volatility hit record highs, jumping 54% within a matter of days (Figure 1), as a result of the coronavirus crisis, its economic repercussions and the oil price war in the second half of March, the ETF market has been in the spotlight. There has been widespread comment that many ETFs’ steep discounts to net asset value (NAV) – most notably in the high yield bond sector but throughout fixed income, commodities and even equities – were somehow a reflection of a dysfunctional market.
Certainly, there have been some dramatic price movements in the secondary market. Bloomberg reported that by March 20th around 70 fixed income ETFs in the US were trading with at least a 5% discount to NAV while 16 traded at a discount of 10% or greater. One high yield ETF reached a 28% discount, while even short maturity bond ETFs, which given their limited duration might be assumed to be less prone to volatility, saw dramatic swings during this period.1
However, despite this volatility the way ETFs are structured has been shown, once again, to be valuable when there are imbalances in the market between supply and demand. Broker-dealers can go straight to the ETF market and create new shares in the primary market to overcome these short-term challenges. The statistics back this up. Primary market order numbers in March were 223% higher than the average over the past three years (Figure 2).
Many years ago, before the financial crisis, it was assumed that ETFs always traded at around NAV. The market volatility of 2008 and 2009 put paid to that. But the perception that ETFs should not trade at a significant premium or discount to NAV has persisted. In order to get a proper perspective on the issue, it is important to remember that ETFs are traded instruments. Consequently, any imbalance between supply and demand will invariably have repercussions for spreads and pricing.
What is important is that ETFs, unlike closed-end funds – which can trade at extremely sizeable discounts or premiums to NAV for long periods – have a readily available mechanism to minimize the impact of any disparities between supply and demand. While closed-end funds can issue new shares to reduce a premium or buy back shares to narrow a discount, this is a time-consuming process, usually at the manager’s discretion, or which requires specific authorization.
In contrast, ETFs have a highly dynamic real-time mechanism embedded in their structure that facilitates secondary market liquidity and minimizes the potential scale of any discount to NAV due to volatility in the underlying assets. As open-ended instruments, ETFs can create or redeem shares from inventory. Most importantly, this creation and redemption can occur automatically according to the needs of broker-dealers and with no specific authorizations required. During periods when demand for ETFs drops substantially, such as the second half of March, the authorized participant or market maker can still buy an ETF from an investor at a certain price and know that they can redeem it at NAV; that means they are still able to make the arbitrage spread, which for other product types may not be the case.
The NAV on an ETF is struck every night. In a liquid market, such as an equity index, it can be based largely on final trading prices. But in illiquid markets (like most bond markets) it is essentially an estimate of fair value based on the last traded price and assumptions about likely value given changes in market conditions and sentiment. Moreover, it produces a result that has a time lag – it reflects the previous day’s assumptions. To confirm this point, we looked at three different investment strategies2 within the ETF wrapper to see how they performed from March 9th to March 20th. The results showed that the market price was a leading indicator of where the ETF’s NAV would price the following day, providing a true reflection of value. When necessary, primary market ETF volume increased in concert with movements of the secondary market.
In the two most recent bouts of significant market volatility (Q1 2020 vs. Q4 2018), ETFs have been a resilient source of stability in the market. Our analysis shows that commission-based programs, where mutual fund assets are dwindling and money market assets are entrenched, ETFs have seen steady growth.
While mutual funds have experienced the most prominent outflows within commission-based and Rep-as-PM programs, one thing to keep an eye on in the future is money market funds’ continued penetration in commission-based programs. For fully discretionary advisor-driven programs, it will be interesting to monitor whether their run of growth in terms of net sales continues as volatility subsides.
As asset managers look to gain a better understanding of how advisors are leveraging a combination of active and passive strategies, it’s critical to arm sales, marketing and product teams with actionable data-driven insights. One central theme in the industry has been the increased importance of using data across these respective groups to ultimately help drive sales efforts.
To that end, BNY Mellon will continue to provide clients with insightful, relevant analysis through its Intermediary Analytics solutions. BNY Mellon Data and Analytics Solutions integrates the resources of Intermediary Analytics, Eagle products, and other BNY Mellon technology and data assets to build client-centric technology and content solutions. By providing distribution trend analysis, the Intermediary Analytics solutions will help clients understand the drivers behind advisors’ use of active and passive products, which can be an important first step when engaging with financial advisors.
2 The three investment strategies were: an equity ETF focused on the S&P 500 (Product A), a fixed income ETF focused on bank loans (Product B), and a fixed income ETF focused on short duration (Product C)
3 OCP supplied by NYSE Group, NYSE Connect and NAV supplied by BNY Mellon ETF Fund Accounting