Good Time To Revisit How an ETF Works

Posted on March 27, 2020 by Gemmer Asset

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Bull and bear markets are funny things. When the markets are soaring, no one seems to ask many questions and if they do, they don’t dig too deep. During big downturns, everyone is asking questions and trying to figure out how various financial instruments actually work. Given all the chaos recently, we thought it would be a good time to revisit how ETFs work and discuss how volatility exposes some unique characteristics of this particular type of fund.

 

ETF Basics

 

Exchange Traded Funds (ETFs) are similar to mutual funds in that they are pooled vehicles that hold various assets such as stocks, bonds, commodities, etc. ETFs differ from mutual funds in that they trade constantly on exchanges, just like stocks. This means traders and investors can buy or sell ETFs during the day rather than simply at the end of the trading day. Most ETFs in existence today follow an index strategy (generally termed passive investing), meaning they don’t try and outperform a benchmark, but rather replicate returns of a particular index.

 

Two main benefits of ETFs are their low cost and tax efficiency. The low-cost part is pretty straightforward. Because most ETFs are passive in nature, they incur lower administrative and trading costs than actively managed funds.

 

The tax efficiency of ETFs is where things start to get complicated. If an investor sells a mutual fund, the fund company must sell some of the underlying holdings in that fund to meet the investor’s redemption request. The sale of those underlying holdings is a taxable event to the fund and if there is a gain, it is passed down to ALL holders of that mutual fund, regardless of if you were the one requesting the redemption. ETFs are more tax efficient because they avoid this issue. Because of their structure, if an investor sells his or her ETF the subsequent redemption of the underlying securities by the fund company is not considered a taxable event.

 

So, How Is The Sausage Made?

 

The mechanics of an ETF center around something called the creation/redemption process. The Financial Times described the process well in an article on bond ETFs yesterday:

 

“When ETF prices drift from the value of the underlying holdings, market makers — known as ‘authorised participants’ in the industry jargon — normally swoop in to close the gap by creating or redeeming shares in the ETF.

Creation is when an AP buys bonds and hands them over to the ETF provider in exchange for a set amount of shares. Redemption is when it gives back shares in exchange for the bonds.

 

In theory, the price of the fund and the value of the debt it holds should be the same. So, if the ETF value drops below the value of the underlying bonds, APs can buy the cheaper ETF shares and exchange them for the underlying bonds.

 

When conditions are reversed, they can buy the cheaper underlying bonds and turn them into ETF shares. Most of the time, this arbitrage keeps an ETF’s price and its NAV in line.”

 

Most of the time…

 

When The Volatility Hits…

 

During normal times, we’re likely to take the inter-workings of Wall Street’s investment vehicles for granted. In periods of extreme volatility however, many of these mechanisms come into the spotlight and exhibit some pretty unusual behavior.

 

Let’s take a look at the iShares IBOXX Investment Grade Bond ETF (ticker: LQD). In the midst of the recent bear market, corporate credit was hit hard, and LQD suffered some of the worst outflows in its history. The following week the Federal reserve said it was going to provide liquidity to the investment grade bond market (more on this below), in part by buying bond ETFs. This caused investors to flood back into LQD to try and get ahead of the Fed purchases. Here is a chart of the daily fund flows:

 

 

And here is what those flows did to the premium and discount to NAV:

 

 

Pretty incredible. The ETF went from trading at a -5% discount to the value of the underlying securities to a +5% premium almost overnight. The average premium over the last 10 years for the ETF has been 0.18%! First, large outflows pushed the ETF price down very fast, faster than the value of the underlying bonds – creating a big discount to NAV. After the Fed announcement, massive inflows pushed the ETF price far above the NAV – showing a huge premium.

 

This may beg the question of which price is correct, the NAV or the ETF price? Well, they may both be right. ETF prices reflect real time tick by tick pricing of securities that may not trade all that often while NAV prices reflect actual trade data of the underlying (this is why big pricing dislocations don’t happen as often with equity ETFs – stocks trade on exchanges, usually more often than bonds and with much more transparent pricing). Comparing the two prices may not be apple and oranges, but maybe granny smith and honey crisp…

 

When these types of dislocations have occurred in the past, authorized participants have stepped in to arbitrage away the difference in price/NAV. We’ve already started to see this happen with many bond ETFs but because volatility is likely to stick around for a while, these dislocations may become more commonplace.

 

A Quick Lesson In Diversification From… The Fed??

 

We mentioned that the Fed is going to inject liquidity into the fixed income markets by buying corporate bonds. In their statement they said the following (emphasis is my own):

 

“The SMCCF [Secondary Market Corporate Credit Facility] will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.

 

I know the Fed wasn’t trying to make a point about diversification, but the inference is pretty powerful. They’re essentially saying that the most efficient way for them to buy bonds is via ETFs. Sure, they’ll buy individual bonds where it makes sense, but if they want to impact broad swaths of the investment grade market, ETFs are the perfect tool. The hidden lesson here is that if an investor wants broad, diversified exposure to an asset class, ETFs can be a great way to accomplish that – pricing irregularities and all.

 

 

 

 

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