Hidden Depths of ETFs

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April 2022
 

In March 2020, equity and bond markets1 experienced historic volatility, during which liquidity temporarily dried up, making trading difficult. Exchange-traded funds (ETFs) saw their spreads widen during this time, and many traded at a discount to their net asset values (NAVs)—meaning the price to buy them was less than their worth. But that wasn’t necessarily a bad thing. Here, Stephanie Pierce, CEO of ETF, Index and Cash Investment Strategies at BNY Mellon Investment Management, answers some questions about the effect of volatility on ETFs and what discounts and premiums really mean for such products.

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.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, contact your financial advisor or visit im.bnymellon.com/etf. Please read the prospectus carefully before investing.

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.

This material has been provided for informational purposes only and should not be construed as tax advice, investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.

This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

BNY Mellon Investment Management is one of the world’s leading investment management organizations, encompassing BNY Mellon’s affiliated investment management firms, and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2022 BNY Mellon Securities Corporation, distributor, 240 Greenwich St., New York, NY 10286.

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