ETFs proved their resilience through the volatility and, beyond that, acted as instant market access tools, as well as providing price discovery and liquidity for investors, during the recent stressed market scenario, according to a note by DWS’s capital markets team.
Bhaven Patel, DWS Xtrackers ETP Capital Markets Senior ETF Capital Markets Specialist, Jamie Hartley, DWS Xtrackers ETP Capital Markets Senior ETF Capital Markets Specialist, and Cesar Muro, Head of Passive Sales Spain and Portugal, report that equity ETF trading has generally been as expected in the secondary market within the creation and redemption cost range either side of the net asset value (NAV), albeit with a wider range than normal.
“As expected, any ETF trading significantly higher or lower than its primary market creation or redemption cost has experienced the normal arbitrage process to bring the ETF price back in line close to NAV. The transparency of the equity market structure has helped ETF brokers have relative certainty and confidence when pricing intraday or similar versus NAV. This has been further supported by equity indices which use transparent and generally achievable official equity close prices for their index levels which ETF NAVs are referenced to.”
Fixed income proved more testing, and the team writes that the bond market has moved rapidly during the COVID-19 period along with credit spreads to levels not experienced since 2008. However, they write that at a time when bond liquidity has significantly reduced, fixed income ETFs have performed well.
“Firstly, despite the prominent reduction in underlying bond liquidity we have seen unprecedented trading volumes for fixed income ETFs. The structure of the ETF ecosystem allows trading to take place in the secondary market without execution of the underlying securities or the creation redemption of ETF units, thus enhancing overall ETF liquidity. Subsequently, during the COVID-19 period, we have seen a material increase in the secondary to primary market ratio of fixed income ETFs.”
As an example, DWS writes: “Some fixed income ETFs saw over a 270 per cent increase in secondary to primary activity during March 2020 compared to 2019 averages.
“To put this into perspective, the 2019 average ratio for the same fixed income ETFs was 1.3x. During the virus period this has increased to 3.5x meaning that for every EUR3.5 traded in the secondary market, only EUR1 is traded via the primary market mechanism.”
The team writes that these statistics demonstrate the extensive and unique benefits of the ETF ecosystem and how the recycling of already issued ETF shares provides a liquidity buffer which prevents instant one-for-one risk transmission from the secondary market to the primary market.
Furthermore, the paper’s authors add that where investors have struggledto execute single cash bonds, ETFs have served as an efficient price discovery tool trading at live executable prices and a reflection of the true fair value of the underlying securities.
They note that the outstanding value of corporate bonds has increased substantially in the last decade and in turn, the inventory of bond dealers has also been significantly reduced since the great financial crisis of 2008.
“Subsequently, as a result of the far bigger corporate bond universe, when a market sell off occurs, there is arguably less liquidity sleeves in the market to absorb major shocks.”
The authors also examine the phenomenon of fixed income ETFs having a discount to NAV.
“Structural differences between the market structure of equities and bonds resulted in a temporary dislocation between fixed income ETF prices and their NAV which were not experienced by equity ETFs. The dislocation resulted in the trading prices of fixed income ETFs appearing to be heavily discounted below their NAV.
“The main driver of the dislocation can be attributed to the bond prices used by index providers, which ETF NAVs are benchmarked to. Index providers need to obtain a price for every bond in their respective index and different providers can have their own pricing source and methodology. Prices of bonds need to be obtained at a certain ‘fixing’ time but as bonds are not traded on transparent and widely accessible venues similar to equities, index providers may ask a panel of broker-dealers at a certain time for indicative (non-firm) prices. Alternatively, algorithms can be used to model the theoretical fair value of a bond. In many cases if the bond has not been traded during the day a stale price reflecting when the bond last traded is the only viable option to use.”
The team comments that the fixed income market does not operate like the equity market, i.e. it is not standardised, it is very fragmented, there is no official market and there is no closing auction period.
“Therefore, it does not have the same transparent price visibility as equity shares. In the end, the ETF NAV or any other traditional fixed income investment fund shows a theoretical bond price that is indicative, reasonably estimated and as close as possible to a fair value. Therefore, bond indices can include many theoretical prices which are not necessarily tradeable prices.”
Under normal market conditions, this causes fixed income ETFs to trade at small differences to NAV as ETF brokers will price in any difference they see between the tradeable prices of the underlying bonds versus where the index has priced the bonds.
However, in times of severe market volatility, such as in recent days where markets have moved at dramatic speeds, these small differences are amplified to a much larger extent and will result in dislocations between the intraday tradeable price of the ETF, which is based on the live tradeable prices of the underlying bonds, and its NAV, which is using theoretical or stale prices.
DWS notes that in some cases, depending on the specific ETF exposure, some fixed income ETFs were seen to be trading at heavy discounts between 2 per cent to 7 per cent below the NAV of the ETF.
“Although bond traders know these theoretical bond fair values from pricing services, they have to estimate the value of bonds that are not trading and as a result, the actual bid price at which they can sell the bonds may be at much lower levels. This is a typical stress scenario in markets with insufficient liquidity to absorb the avalanche of sell orders in the underlying bond market. It is important that we acknowledge that this is not specific to ETFs, but to how bond market pricing works in its broadest sense,” the team writes.
As already mentioned in the equity ETF section, any significant tradable disparity between the ETF price and its NAV or fair value, would imply an arbitrage opportunity for Authorised Participants (APs), those who can create and redeem ETF shares with the respective ETF provider.
DWS explains that, given certain market conditions, Authorised Participants can arbitrage with the following actions:
1. Buy ETF shares at discounted price until there are no more discounted ETF shares.
2. Sell the equivalent sized basket of underlying bonds at their normal market price.
3. Submit in-kind redemption with the ETF issuer to deliver the ETF shares (at NAV) in exchange for the underlying basket of bonds (NAV equivalent bond prices).
4. The Authorised Participant is now flat on their ETF and underlying bond positions and has locked on the profit between buying the discounted ETF shares and selling the underlying basket of bonds.
DWS writes that the fact that during the market volatility so far no obvious arbitrage occurred and the discounted ETF prices remained, demonstrated that there was no obvious arbitrage opportunity and that market participants agreed that the ETF prices were based on the actual tradeable prices of the underlying bonds whilst the NAVs were using stale or theoretical prices.
