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Navigating ETF Discounts and Premiums During Turbulent Times – A U.S. Example (Part 1)

Recent market volatility has led to extraordinary dislocations in ETF prices.

Ben Johnson, CFA 16/04/20

Key Takeaways: 

  • Market volatility has caused many exchange-traded funds to trade at extreme discounts to their net asset values.
  • ETF investors should understand ETF premiums and discounts and how to best navigate them.
  • If possible, ETF investors should avoid trading during unstable periods in the market. If they must trade, using limit orders is a best practice. And for those investors that don't place any value on ETFs' intraday liquidity, mutual funds offering similar exposure are perfectly suitable options.

 

Investors Are Flocking to ETFs
As markets have been roiled by the spread of the coronavirus and flailing to price the implications for economic growth and corporate earnings, ETF trading has spiked. Shares of SPDR S&P 500 ETF (SPY), the oldest and largest U.S. ETF, have changed hands in record volumes. On Feb. 28, 2020, SPY's trading volume hit $114 billion--an all-time high, equivalent to 5.6 times its average daily volume during 2019 and representing 43% of its assets under management. According to Bloomberg data compiled by BlackRock, ETF trading accounted for 38% of all equity volume on U.S. exchanges from Feb. 24 through March 13. This compares with an average of 27% in 2019. What explains this uptick?

ETFs are a dynamic investment wrapper. They can be used by long-term investors as low-cost, tax-efficient portfolio building blocks. They have penetrated actively managed funds as a means of maintaining market exposure and managing liquidity needs. They can be sold short by those with a bearish view. And they've become an additional layer of liquidity in fixed-income markets, stepping in where traditional bond market participants have stepped out in the post-financial-crisis period. Given these funds' diverse use cases and user base, it is no surprise that investors of all stripes have flocked to them in a market that--to put it lightly--has been liquidity-challenged.

Unprecedented Dislocations
ETFs trade like stocks. Investors pay or receive the going market price for their shares. These prices tend to hew closely to the value of their underlying assets. ETF market makers make sure of this. They are the linchpin of the ETF ecosystem. They quote bid and ask prices for ETF shares and compete with one another to profit from any discrepancy between the funds' share prices and their own estimates of the value of the funds' assets.

In normal market conditions, market makers face little risk and ample opportunities to collect profits from keeping prices in check and pocketing bid-ask spreads in exchange for connecting ETF buyers and sellers. But these aren't normal conditions. Today, the risk market makers face has flared and the demand for their ability to price them has peaked. As a result, they are having greater difficulty and facing bigger risks pricing ETF portfolios and are quoting wider bid-ask spreads.

In the early days of the current market meltdown, ETFs were weathering the storm well. While bid-ask spreads and premiums and discounts widened, they remained within normal ranges.

During the week of March 9, as the going got tougher, many ETFs saw their prices come unmoored from their NAVs. This owed to a variety of factors, but tumult in the Treasury market played a big role. The impact was immediate and significant. The March 12 closing prices for Vanguard Total Bond Market Index ETF (BND), iShares Core U.S. Aggregate Bond ETF (AGG), and Schwab U.S. Aggregate Bond ETF (SCHZ) represented respective discounts to the funds' NAVs of 6.2%, 4.4%, and 6.3%. In all cases, these were well, well outside of normal ranges--none of these funds had ever seen discounts of this magnitude.

To be clear, these funds were not alone--abnormally large premiums and discounts have been pervasive. In one extreme case, VanEck Vectors High-Yield Municipal Index ETF (HYD) closed at a 19.3% discount to its NAV on March 12. But I chose to highlight these three because they are among the largest funds offering access to the most liquid segments of the fixed-income markets. BND is the ETF share class of the world's largest bond fund. These are not the funds that anyone--myself included--would have expected to behave as they have in stressed markets.

What are investors to make of all of this? How should they respond? Before I dive into the details, I think it is worth revisiting the basics of ETF premiums and discounts in part 2 of this article.

About Author Ben Johnson, CFA

Ben Johnson, CFA  

Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.