Generally, we expect ETFs to trade close to their net asset value (NAV) due to the redemption mechanism that allows authorised participants to arbitrage between the ETF shares and the underlying shares.
However, in this recent period of heightened volatility and dislocation due to COVID-19, a number of ETFs have been trading at significant discounts, especially fixed income ETFs with large allocations to credit and high yield.
At the market’s close on 18 March, some of these discounts had narrowed to a small degree, but still ranged from -2% to -8%. The main issue is been the disruption to price discovery as credit markets have come under heightened stress, especially in the wake of the heavy falls in oil prices.
On the global equity ETF side, there has also been evidence of enhanced spreads immediately after US futures markets going into ‘limit down’ after breaching the -5% limit. The reason is that, due to time zone differences, market makers need to use futures markets as proxies when regional markets are closed and the ASX is open.
Without the S&P 500 futures markets to use as a proxy, market makers cannot effectively hedge their risk premia and need to use less-than-perfect proxies, exposing them to basis risk. This then narrows as regional markets open.
As a general observation, though, it’s fair to say that the local ETF market is holding up reasonably well in what has quickly turned into a severe market dislocation event. Markets such as these also shine a light on the golden rule for ETF liquidity, which is that the more liquid the underlying portfolio, the greater the efficacy of market making activities.
For example, cash and enhanced cash ETFs (such as BILL, AAA) are trading at NAV and have had basis point spreads, and large ASX ETFs have also been trading very well from a spread perspective. Importantly, while it is hard at present to gauge how long markets will stay volatile, the discounts and spread volatility should ease as markets normalise (whenever that might be).
The final point is that T+2 settlements for ETFs are very valuable in a ‘cash is king’ market such as this. This, along with the efficiency in implementing trades, has no doubt been behind the strong trading volumes we have seen, especially in larger ETFs.