During the recent market volatility, we’ve received questions about premiums and discounts in exchange-traded funds (ETFs), particularly bond ETFs. Our take is that the recent market dislocations amount to another “stress test” that ETFs have so far been passing with flying colors. But there are three points investors can keep in mind to help prevent misunderstandings on this topic.
1. An ETF’s net asset value (NAV) may not be the best indicator of its fair value in certain asset classes, particularly during volatile periods.
2. ETF premiums and discounts during periods of market stress may not be as relevant for most long-term investors.
3. ETF trading best practices are even more important in volatile markets.
But first, what are ETF premiums and discounts?
ETFs trade at prices agreed upon by buyers and sellers on exchanges throughout the day. Mutual funds, on the other hand, trade only once per day at NAV, which is priced after the market close. The NAV of any ETF or mutual fund represents each share’s slice of the fund’s total assets (stocks, bonds, cash, etc.), minus its liabilities.
When an ETF’s intraday share price is trading away from the NAV, the ETF is trading at a discount or premium. Most of the time, ETF share prices stay close to NAV.¹
However, ETF pricing can be a bit more complex when markets become turbulent. In volatile periods, an ETF’s NAV becomes stale faster as the market participants are able to price in new information in real time, which brings us to our first point.
1. An ETF’s NAV may not be the best indicator of its fair value in certain asset classes, particularly during volatile periods
There are times when it makes sense for an ETF market price to move away from NAV—as when new information, immediate liquidity demands, or widening of bid/ask spreads aren’t well reflected in the ETF’s most recent NAV. In volatile periods, continually updated market prices are pulling in comparatively more information at a faster rate—so that can account for more pronounced or more volatile premiums and discounts. In the recent volatility, bond ETFs have offered an interesting example of NAVs going stale. But it should be recognized that the volatility has only amplified an existing bond-pricing dynamic.
Price and transaction reporting are more opaque in bond markets compared to equity markets. Most parts of the fixed-income market trade off exchange or “over the counter” (OTC), at negotiated prices, and there are no uniform trade reporting facilities as in global equity markets. Also, because of the nature of bond market structure, many fixed-income securities don’t trade actively on a given day. In the case of corporate credit and municipal debt, individual bonds may not trade for days, which makes pricing more challenging to gauge. Therefore, when a fund holding bonds calculates NAV, the pricing of some of the securities involves using proxies and estimates from bond pricing services and other theoretical pricing methods. For bonds that haven’t traded for several days, fund accountants may use changes in interest rates, credit spreads, and other factors to estimate the fair price. But it’s still an estimate. Equities, meanwhile, are generally more transparent and price reporting is more frequent and centralized through the regulated exchanges that they trade on.
An ETF transaction occurs when a buyer and seller agree on a price. That’s why a bond ETF’s intraday market price may offer a more accurate picture of the value of the underlying bonds than the NAV calculated at the prior day’s market close. This is what’s meant by ETF “price discovery” in volatile markets. While an ETF can provide immediate liquidity and price discovery during swiftly moving markets, this also may lead to intraday supply or demand imbalances for shares of the ETF itself.
With most ETFs being structured as open-end funds, authorized participants (APs) can create or redeem shares on any given day, which gives APs a profit motive to keep the ETF’s market price close to the value of underlying assets. APs are brokers, financial institutions, and market makers that can interact directly with ETF sponsors to create and redeem large blocks of shares of the ETF—typically between 10,000 and 100,000 shares—called creation units, based on supply and demand for the ETF. APs have the ability to create and redeem shares, but they need to manage the short-term risks and costs of these supply/demand dynamics until they can conduct creation and redemption activity. Those costs and risk may materialize in the form of temporal premium or discounts.
Lastly, the fact that a bond ETF representing a diversified portfolio of fixed-income securities may trade at a given market price during the day, or a mutual fund holding a similar portfolio of bonds may trade at the end of the day at NAV, doesn’t necessarily mean that each individual bond held in the fund trades on that given day. The truth of the matter is that the “right” prices of some these fixed-income securities may be somewhere between where the ETF market makers are pricing them and where the pricing of the NAV is implying that price may be.
Periods of extreme market stress tend to exacerbate these differences. The lack of transparency, and the more complex market structure in the bond market, makes it difficult to know exactly what the right price is for a given security. Still, most long-term investors aren’t trading in volatile markets, which takes us to our second point.
2. ETF premiums and discounts during periods of market stress may not be as relevant for most long-term investors
ETFs provide immediate liquidity and let investors transfer risk in volatile markets when their underlying holdings may be stressed. As we’ve covered here and in past blog posts, ETFs have a network of APs and market makers that help facilitate real-time pricing, trading, and creation and redemption of ETF shares.
Yet, ETFs don’t provide some magical liquidity to the underlying asset class, whether it’s U.S. stocks or high-yield corporate bonds. If liquidity is challenged and bid/ask spreads are widening in the underlying securities due to volatility, determining the ETF share price involves more risk. In some asset classes, such as high-yield corporate bonds, ETFs have become the most popular place in town for expressing a view on the market, and that ability to trade in real time during volatile days may involve wider trading spreads and potentially lead to wider ETF premiums and discounts.
That said, long-term investors generally aren’t affected by short-term premiums and discounts. If they hold through the volatility, investors realize the ETF’s NAV performance experience over the entire holding period. In the past, these episodes of outsized premiums and discounts haven’t lasted long once volatility subsides.
In the recent period of stress driven by concerns about the coronavirus (COVID-19) outbreak, the U.S. Federal Reserve announced it will directly buy several forms of fixed-income securities, such as corporate bonds—as well as corporate bond ETFs—in an attempt to provide a liquidity backstop to the broader fixed-income markets. This has helped narrow discounts, and in some cases has led to investment-grade corporate bond ETFs trading at a slight premium to their NAV.
3. ETF trading best practices are even more important in volatile markets
Although long-term investors should resist the urge to panic-sell, there are a few best practices for trading in volatile markets if portfolio rebalancing or tax-loss harvesting, for example, are key objectives.
Best practices include avoiding trading near the open and close of the markets, and using limit orders rather than market orders for ETF purchases and sales.
Most financial professionals and individual investors have the ability to use their broker-dealer’s block trading desks. These professional trading resources become even more valuable during periods of market stress.
In periods of elevated volatility, questions about ETF premiums and discounts invariably arise. But for long-term investors, short-term premiums and discounts in ETFs are mostly just sound and fury, but act as a reminder that investors of all stripes should focus on best practices when trading any security in a volatile market.
1 There can be no assurance that active trading markets for the shares will develop or be maintained by market makers or authorized participants, and there are no obligations of market makers to make a market in the fund’s shares or to submit purchase or redemption orders for creation units. Although market makers will generally take advantage of differences between the NAV and the trading price of fund shares through arbitrage opportunities, there is no guarantee that they will do so. Decisions by market makers or authorized participants to reduce their role with respect to market making or creation/redemption activities in times of market stress could inhibit the effectiveness of the arbitrage process in maintaining the relationship between the underlying value of the fund’s portfolio securities and the fund’s market price. This reduced effectiveness could result in shares trading at a discount to NAV and also in greater-than-normal intraday bid/ask spreads for shares.