ETFs have remained open for business during the coronacrisis, while credit markets were largely frozen. But ETFs were still able to cope with unprecedented outflows, providing investors with badly needed liquidity. However, this may just be a Pyrrhus victory for the index providers.
Providers of index trackers took the opportunity to send out exuberant press releases featuring headlines such as ‘ETFs are made for these times’ (iShares) and ‘ETFs pass bear market test’ (LGIM). Wim van Zwol, head of Benelux at Vanguard, stressed that the ‘extra layer of liquidity’ offered by ETFs during the corona crisis comes in particularly handy as trading in many individual bonds has come to a virtual standstill.
Trading in ETFs was able to continue, however, as this mainly involves secondary market trading. ‘More than 80% of ETF transactions take place between investors. This involves selling shares in ETFs. Only in 10-20% of the transactions, bonds or shares are actually bought or sold on the stock exchange,’ says Van Zwol.
‘ETF outflows trigger volatility’
But what if investors in ETFs look for the exit all at once, as they have done in recent weeks? In the third week of March alone, investors sold $19 billion worth of investments in bond ETFs. ‘ETFs do indeed provide liquidity for their holders, but they have mainly been sellers in this crisis. That’s why I’m not so sure they’ve actually contributed to liquidity in recent weeks,’ says Chris Iggo, CIO Core Investments at AXA IM.
ETFs also provide easy access to speculative investors. ‘The huge outflow from ETFs over the last few weeks has, in my opinion, therefore fuelled volatility, adds Iggo’s colleague Jonathan Baltora.
‘It’s important that investors’ expectations are aligned with the way ETFs work and perform,’ a spokesperson for Dutch financial regulator AFM told our sister publication Fondsnieuws. ‘Depending on market conditions, liquidity in the underlying bonds may disappear or trading costs may increase, for example in the recent bear market’, he added.
Pricing difficulties
This problem has played a major role in the bond markets in recent weeks. Despite the disappearance of liquidity in parts of the market, trading in ETFs was busier than ever, and they continued to issue prices. For example, the iShares USD Corp Bond UCITS ETF was traded 1000 times on 12 March, while the five largest bonds in the index changed hands only 37 times on average.
‘Pricing is difficult in such an illiquid market. As a result, an ETF can sometimes quote lower than its intrinsic value if the underlying bonds are very difficult to price and you’re therefore dealing with a lot of old prices in the market,’ says Vanguard’s Van Zwol. Even in relatively liquid markets, such as government bond markets, ETFs traded at substantial discounts. According to an analysis by Reuters, European bond ETFs have been trading at discounts of between 2 and 11% compared to their net asset value over the past few weeks.
‘But it doesn’t mean there is a problem with the structure of ETFs just because they are trading at discounts,’ says iShares. ‘On the contrary, ETFs are a leading indicator of market prices because they are traded much more often than individual bonds, especially in times of market stress.’
The role of ETFs in the bond market is very limited compared to the equity market, accounting only for about 1% of assets, Van Zwol of Vanguard notes. ‘The impact of trackers on the bond market should therefore not be exaggerated,’ he says.
Pyrrhus victory
The question remains whether the corona crisis will have a positive or negative impact on ETFs. Van Zwol expects that investing in bond trackers in particular will now receive an extra boost. ‘Index investing in bonds is still relatively new, while the benefits are the same as for equities. Bond ETFs have passed the liquidity test, and I think this will reinforce the trend towards passives. That’s what happened in the previous crisis too, by the way.’
But is this crisis really a boost for passive? At most, it’s a Pyrrhus victory. As far as assets under management are concerned, ETFs have suffered huge setbacks. For the past ten years, ETF data provider ETFGI has traditionally sent out a monthly press release featuring the total assets invested in ETFs. Almost every month there was a new record. But with the price declines of the past few weeks, combined with record high outflows, it will most likely take years before a new record is set.
And perhaps a crisis like this one offers an opportunity for active investors in particular to halt the rise of passive investment. ‘Passive bond investors also invest automatically in the bonds at risk of downgrades or bankruptcy,’ says AXA IM’s Iggo. ‘In contrast to active investors, they cannot sell these bonds so they’re exposed to this risk.’ One thing we know for sure: exciting times are ahead of us.