The U.S. stock market has quickly lost more than 20%, and investors are understandably nervous about the direction of the coronavirus outbreak. However, we believe investors in exchange-traded funds (ETFs) may be able to better navigate volatile markets by keeping a few basic principles in mind. These include resisting the urge to panic-sell, understanding the basics of how ETFs work, and using limit orders.
ETF basics for volatile markets:
- Resist the urge to panic-sell and trade
- Understand why net asset value (NAV) premiums/discounts may occur
- Avoid trading at the market open/close
- Use limit orders
ETFs were stress-tested again
ETFs have been around for about three decades, and global assets have steadily climbed to above $6 trillion heading into 2020.¹ They've become part of the plumbing of global capital markets.
In previous bouts of market volatility, ETFs have faced questions over their ability to function through the turbulence, and whether they may even contribute to it. Yet in every case, ETFs have traded through the storm, and may even provide price discovery when underlying markets freeze up.
Consider that ETFs have already been stress-tested by market panics such as the dot-com crash, global financial crisis, and the flash crash, to name a few.
In the recent turbluence concerning the impact of the coronavirus, U.S. equity markets experienced historic levels of volume and volatility. During the period of February 28—March 12, 2020, U.S. equity volumes surged to all-time highs, with U.S. equity markets experiencing single-day volume of nearly $1 trillion during the most chaotic days.² We also saw several market-wide circuit breaker trading halts (with the S&P 500 Index experiencing daily drawdowns of more than 7%), and several thousand individual securities halts across U.S. markets.
During this period, ETF trading rose materially as a portion of that overall extreme market volume, with U.S. ETFs making up over 40% of exchange activity, compared to historical averages of closer to 25—30%.³ Despite these surges in trading volumes and volatility, ETFs provided investors with a transparent vehicle to efficiently transfer and hedge risk exposures of all kinds.
Just because ETFs can be traded, it doesn’t mean they should
One of their key differences from mutual funds is that ETFs can be traded during the day, just like an individual stock. However, long-term investors may want to resist the urge to use that flexibility to sell in a panic just when the market hits bottom. ETFs have some attractive structural features, such as transparency and tax efficiency. However, the ability to trade ETFs in real time isn’t as relevant for investors who take a proper long-term view on reaching their financial goals.
For example, ETFs that employ strategies backed by academic research, such as multifactor investing, require a long-term view and discipline, similar to any other investment vehicle designed for a specific experience. Overall, we believe the ETF market is evolving into a popular vehicle of choice for asset allocators, factor investors, and even active management.
Premiums and discounts: what to know
An important feature of ETFs for investors to understand during periods of market stress is the concept of premiums and discounts. When the price of an ETF share trades away from the NAV of the underlying holdings, it's said to be trading at a premium or discount to NAV. ETFs are designed to trade close to NAV due to their creation and redemption feature.
However, there are times when an ETF may trade away from NAV, but the ETF is still acting as it should. This can happen when the underlying market the ETF invests in is closed, such as international or emerging-market countries, or under duress, such as high-yield corporate bond markets. In some cases, ETFs actually become a “price discovery” vehicle when trading in the underlying securities is stale, delayed, or perhaps liquidity in the underlying market dries up.
Use ETF limit orders
We believe long-term investors should resist the temptation to trade in whipsaw markets, as already discussed. Yet, if investors are using ETFs in volatile markets, there are a few rules of thumb to keep in mind.
First, investors may want to avoid buying or selling ETFs right after the market opens, and right before it closes. In periods of extreme market stress, like we've seen this month, this best practice becomes even more critical. In the first and last 30 minutes of trading, ETF spreads can be wider due to higher volatility and other factors.
Also, investors buying or selling ETFs in volatile markets should consider using limit orders, rather than market orders. A market order is designed to buy or sell the ETF quickly at the market’s best price. In periods of volatility, the market’s best price may not match investor expectations. Limit orders, on the other hand, provide some protection in fast-moving markets because they only buy or sell at a predetermined price.
Continuing ETF education
As with each bout of market volatility, questions surrounding ETFs' structure and the role they play in that volatility come to the forefront. This time has been no different. However, ETFs have continued to let investors transact and manage risks in markets that are seeing historic price swings and trading volume.
1 “ETFGI reports assets in the global ETFs and ETPs industry which will turn 30 years old in March started the new decade with a record 6.35 trillion US dollars,” etfgi.com, January 16, 2020.. 2 Bloomberg, as of March 12, 2020. 3 Bloomberg, as of March 12, 2020.
Past performance does not guarantee future results.