How liquid are ETFs during market volatility? Why do ETFs help markets function?
ETFs provide liquidity and price discovery during market volatility, especially for the fixed-income markets. It would be extremely difficult to trade during these times without them. ETF market makers and authorized participants provide transparency into where the underlying assets within ETF portfolios should be trading. While equity ETFs declined in value during the extreme volatility seen in markets in March 2020, they were constantly trading, thereby providing market participants with an important tool for price discovery and liquidity.
How can ETFs help during volatile time periods?
If you consider a functional fixed-income market, the most liquid corporate securities trade approximately a dozen or two dozen times a day. ETFs, on the other hand, trade much more frequently. They trade tens of thousands of times a day. As such, they can become a tool of price discovery. For example, if an ETF were trading at a 5% discount to NAV, that means the bond prices are stale and they are actually 5% higher than where the market really thinks they should trade. There seems to be a lack of understanding of what discounts and premiums really mean. They are a feature of ETFs, not a flaw. Corporate bonds don’t trade very frequently. In times of large price dislocations, the market doesn’t know where corporate bonds should be trading. ETF discounts and premiums provide some visibility into where the markets should trade.
How does a premium relate to the underlying markets of the securities that the ETFs hold?
An ETF can represent a whole market segment. For example, an EAFE ETF holds securities in Europe and Asia. Those markets close well before the US markets do. An ETF that trades on a US exchange will continue to trade up until 4 pm, even though the underlying securities are no longer trading. If there is any positive market news after the EAFE markets close, it won’t affect the ETF’s NAV since the value is based on the closing prices of the European and Asian securities. The ETF price, on the other hand, will be affected by any positive news. So, the ETF price could be momentarily higher than the NAV—or at a premium—thereby reflecting the positive news after the EAFE markets closed.
1 “What Happens to the Stock Market After a Recession?” Forbes, April 3, 2020; and “First-Quarter Sell-Off Soon Roils Calm Fixed-Income Market: The global pandemic caused fixed-income market volatility not seen since the global financial crisis,” Morningstar, April 7, 2020.
Note: This article looks back on a period of extreme volatility in the stock market. This volatility was unique to the time frame discussed and may not be repeated. Should extreme volatility occur again, there is no guarantee that ETFs would react or perform in the way discussed in this article. Past performance is no guarantee of future results.
All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks. Any views and opinions are those of the investment manager, unless otherwise noted and is not investment advice.
Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.
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ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF’s per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF’s shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.
ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High-yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories. Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries. Past performance is no guarantee of future results.
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