Equity and fixed-income markets have been challenged this year, with many broad market indexes seeing double-digit declines. Despite market volatility, investors continue to turn to exchange-traded funds (ETFs), not only as useful tools to navigate choppy markets but also as efficient building blocks of their portfolios alongside mutual funds and other vehicles. This is evidenced by over $500 billion in ETF net inflows so far this year across both equity and fixed-income ETFs, including both active and passive strategies. Here are a few principles to keep in mind when using ETFs to navigate volatile markets.
ETF basics for volatile markets
- Resist the urge to panic sell and trade
- Understand why NAV premiums/discounts may occur
- Avoid trading at the market open/close
- Use limit orders
ETFs survive another stress test
ETFs have been around for nearly three decades, and global assets have climbed to above $8 trillion as of September 2022. 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 they 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 COVID-19 pandemic.
This year, inflation that’s reached levels not seen in four decades has created a previously unseen challenge for ETFs. Central banks around the world have taken aggressive action to slow the pace of price increases to a normalized level, creating stress for both equity and fixed-income markets.
Yet against the backdrop of this market turmoil, ETFs continue to trade smoothly. Throughout 2022, ETF trading has regularly made up as much as 30% to 40% of the total U.S. exchange value traded. Just as they did during March 2020, ETF trading volumes tend to increase during times of market volatility, likely due to their ease of trading.
Emphasizing investor confidence in the wrapper, ETFs continue to gather assets and are on pace to post their second-best year of flows. ETF issuers also seem eager to meet growing investor demand for these products, with the U.S. marketplace growing to now include over 3,000 different ETFs. As of the end of November, ETF launches have outpaced closures by a measure of nearly three to one.
Overall, ETFs seem to be sailing through yet another storm unscathed, providing investors with a growing number of choices to use 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 be
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, but 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 net asset value (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 or 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 couple of basic rules to keep in mind.
1 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, 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.
2 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, but 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.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
It is important to note that there are material differences between investing in an ETF versus a mutual fund. ETFs trade on the major stock exchanges at any time during the day. Prices fluctuate throughout the day like stocks. ETFs generally have lower operating expenses, no investment minimums, are tax efficient, have no sales loads, and have brokerage commissions.
Mutual funds trade at closing NAV when shares are priced once a day after the markets close. Operating expenses may vary. Most mutual funds have investment minimums and are less tax efficient than ETFs; many mutual funds have sales charges and they have no brokerage commissions.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.
This material does not constitute tax, legal, or accounting advice, is for informational purposes only, and is not meant as investment advice. Please consult your tax or financial professional before making any investment decisions.