Exchange-traded funds (ETFs) have, by and large, had a good crisis. These baskets of securities (versions range from equities and bonds to futures and commodities) track an underlying index and are traded like shares on a stock exchange. They have mostly replicated the ups and downs of the major indices faithfully.
Many corporate-bond ETFs, however, haven’t. The concern here has long been that although corporate-bond ETFs are highly liquid and hence easy to trade in and out of, the actual bonds held in the portfolios are a good deal less liquid. So investors might find it easier to sell the liquid assets (the ETFs) rather than the less liquid underlying assets, opening up pricing mismatches.
A gap emerges
Consider the Vanguard Total Bond Market Index Fund ETF (BND), a hugely popular $55bn US bond ETF. It contains some of the most liquid corporate bonds available. Nonetheless, in recent days the spread between the ETF and its benchmark has reached 3%.
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The idea of a mismatch between the price of a fund and the underlying assets isn’t news to anyone who invests in investment trusts, for instance, where discounts open up all the time – but ETFs were supposed to be a more efficient structure. Put simply, major investors known as authorised participants would swoop in to trade the underlying basket of bonds or stocks in an ETF and narrow down that discount. But this is not happening. And that’s because the underlying bonds are not, in truth, that easy to trade in and out of.
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The problem isn’t confined to America. Tom Eckett of industry news site ETF Stream (where I am executive editor) reports that, using data from Bloomberg, “the $7bn iShares USD Corp Bond UCITS ETF, one of Europe’s largest ETFs, was trading at a 7.5% discount to its net asset value (NAV) on 12 March as liquidity dried up in the corporate bond market”.
The problem here is that index companies and the market makers behind the ETFs have different ways of valuing bonds. Index providers measure from the middle of the market (the midpoint between the bid, or the highest price a buyer is willing to pay, and the offer price, the lowest a seller is willing to accept).
Meanwhile, the market maker may well value the bond closer to the bid price, reflecting its view on what the realistic price is if you want to sell a bond. That means you get a disconnect between what the NAV providers are saying and what the market makers are saying. The upshot is often that the market price of an ETF (heavily influenced by market makers when investors are jittery and liquidity is poor) will tend to trade at a discount to the reported NAV (which is calculated by the index providers). In a way, it is a good lead indicator for what is happening with underlying credit markets. Usually these gaps don’t last long. But in periods of turmoil they can appear quickly and persist. It only matters if you need to sell the ETF – which is exactly what happened to so many investors a few weeks ago.
Leave leveraged bets alone
The market turbulence of the last few weeks has been especially punishing for ETFs that leverage up or down the movement of a key benchmark. Normally ETFs track the securities in the underlying index on a 1:1 basis, but the leveraged ones will give you twice or three times the return (or loss). If these trades go wrong, the results can be catastrophic, as investors in two three-times (3x) leveraged oil products discovered.
A clause in their rules was triggered following the plunge in oil prices. The WisdomTree WTI Crude Oil 3x Daily Leveraged and the WisdomTree Brent Crude Oil 3x Daily Leveraged ETFs were suspended on 9 March as they breached the “severe overnight gap event threshold”.
That gives the issuer the option to close something called the swap, which is built into the product; this shuts the fund down. In this case the trigger was a 20% price move.
