By Pasquale Capasso, EMEA ETF Capital Markets at Invesco.

Pasquale Capasso, EMEA ETF Capital Markets at Invesco.

When the Financial Conduct Authority looked into the functioning of ETFs during previous bouts of volatility, the findings appeared to support ETF issuers’ claims about liquidity.

The study was performed months before anyone had even heard of the coronavirus, with the UK regulator responding to concerns that were at the time more focussed on the escalating trade war.

Covid-19 put the spotlight on ETFs once again with analysis not in hindsight but in real-time. ETFs have once again performed admirably, but the period has highlighted certain areas where we believe the fixed income market can be improved.

While funds investing in Treasuries and other government bonds generally saw net inflows during the most volatile period, those with exposure to EM debt, high yield, and even euro investment-grade suffered redemptions.

To put it into perspective, fixed income ETFs listed in Europe enjoyed more than $9.6 billion of net inflows from the start of the year to 20 February but suffered outflows of nearly $14.2 billion over the next month.

Interestingly, the magnitude of outflows compared to some other investment vehicles may be attributable to the way ETFs work. They offer relatively more liquidity than some other structures and, indeed, more than the underlying bond markets in many instances.

Generally, the worst-case scenario for any investment – equities or bonds, ETFs or mutual funds – would be when everyone is trying to sell it. The liquidity of an ETF in that situation would simply be that of the assets in which it invests.

As long as the underlying assets can be priced on the primary market, brokers on the secondary market would be able to quote bid and offer prices for the ETF. The more liquid the underlying assets are, the more liquid the ETF covering those assets should be, accompanied in theory by tight spreads.

ETFs have weathered the storm

When the assets are difficult to price, however, as was the case in some fixed income markets in the latter part of March and into April, brokers will compensate for the additional risk by widening their bid-offer spreads. While this behaviour should be understandable in regard to any market, there are other issues specific to some underlying bond markets.

A study conducted last year showed that, on a normal day, two-way quotes were being made on only around a third of USD corporate bonds. Since bonds are traded over the counter, there are no official “closing prices” as you would find in equity markets, meaning a bond’s fair value, or NAV, needs to be determined in some other way.

At Invesco, we use independent, third-party pricing agents, which removes potential conflicts of interest that you could have if the individuals managing the funds are also responsible for establishing valuations.

Need for greater transparency

A bond’s price may be stale, possibly days old, and trades are sometimes not even reported in some bond markets. This makes it difficult for anyone to assess true value in normal times but even more so in volatile conditions. One way that pricing agents attempt to close the gap is by gathering and averaging quotes from various bond dealers. Of course, the accuracy of these calculations depends on the legitimacy of the quotes provided, and we saw indications of some slippages.

In terms of lessons to be learned, we believe bond markets should move towards more transparency for investors, with all trades reported. This would also help pricing agents determine valuations that are actually tradable rather than ones that create the impression of sizable discounts/premiums.

ETFs used for price discovery

While accurate valuations may have been difficult for most investors to determine, fixed income ETFs continued to trade throughout the difficult markets, effectively acting as a discovery tool for the “true” price. Although they may have been wider than expected, they were prices at which an investor could actually trade.

Not only did ETFs continue to trade, but the reality is we saw both buyers and sellers even on the most volatile days. Just as many people were scrambling to raise funds by selling ETFs and whatever else was liquid in their portfolio, other investors saw the turbulence as an opportunity to enter the market. As a result, many of the trades during the period were buyers and sellers being netted off in the secondary market, with no underlying assets needing to change hands.

Any excess orders that cannot be netted off are executed through the primary market. Authorised participants (APs) agree with the ETF’s portfolio manager what bonds will either be brought into the ETF (for net creations) or sold (for redemptions, which was often the case in the volatile March-April period). Sometimes this will be from existing inventory and, in other cases, from the market. This flexibility can be another advantage for ETFs, as it means the portfolio manager is not forced into buying/selling across the entire index. This can also be an effective tool for rebalancing the portfolio throughout the month, rather than having to do it all at once usually at month-end.

Trading update

Since the March-April volatility, conditions have improved with the Federal Reserve and some other central banks including corporate bonds – and corporate bond ETFs – in their asset purchase programs. This stimulus has driven significant inflows into investment-grade corporate bond ETFs as well as high yield including fallen angels, some of which saw their credit ratings downgraded due to the impact of the coronavirus crisis on their business.

Although conditions have improved, they can remain challenging for certain markets day to day. We continue encouraging investors to contact our capital markets team before trading, especially for particularly large trades so we can possibly help find different ways to execute orders. The flexibility and ability to work trades during the day, where needed, could make ETFs even more attractive especially during volatile times. In fact, having passed the most recent liquidity tests, ETFs could see even stronger demand than before this crisis began.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)