ETFs are considered efficient and liquid investment instruments. But in times of crisis, market prices can deviate significantly from the intrinsic value.
• ETF market prices may differ from net asset value in the short term
• Authorized Participants balance premium and discount through creation and redemption
• At LQD, the average discount widened to 1.39 percent in March and April 2020
Unlike a classic investment fund, an ETF share is not traded directly at the net asset value of the fund assets, but rather continuously on the stock exchange. As a result, the market price may deviate from the calculated value of the securities contained in the short term. If the market price is above the net asset value, it is called a premium; if it is below it, it is called a discount. Such deviations are usually balanced out within a short period of time by the arbitrage mechanism of the ETF structure.
As the Dutch market maker Optiver describes in its educational article “ETF Creation/Redemption and Authorized Participants”, so-called Authorized Participants, or APs for short, take on this compensation function. If an ETF is quoted at a premium, an AP buys the securities contained in the index on the market, delivers them to the fund company and receives newly created ETF shares in return, which it sells on the stock exchange. With a discount, the process works in reverse: the AP buys cheap ETF shares on the stock exchange, returns them to the fund company and receives the underlying securities in exchange, which he sells individually at the higher market price. In both cases there is a profit as long as the difference between the market price and the intrinsic value is sufficiently large. It is precisely this arbitrage incentive that pushes the ETF price back towards the net asset value.
Why the mechanism reaches its limits in crises
In normal market phases, this arbitrage mechanism usually works efficiently, but its effectiveness noticeably decreases under market stress. As shown in BlackRock’s July 2020 white paper, “Pricing and Liquidity of Fixed Income ETFs in the Covid-19 Crisis of 2020,” which was published on the U.S. Securities and Exchange Commission’s website at a meeting of the Fixed Income Advisory Committee, average discounts to net asset value for major U.S. bond ETFs widened significantly during the market dislocations in March and April 2020. For the iShares iBoxx Investment Grade Corporate Bond ETF (LQD), the average discount rose from 0.13 percent in January and February 2020 to 1.39 percent in March and April 2020. For the iShares iBoxx High Yield Corporate Bond ETF (HYG), the value increased from 0.21 to 1.06 percent, and for the iShares 20+ Year Treasury Bond ETF (TLT) from 0.13 to 0.86 percent.
The academic analysis of this phenomenon is provided by a study by Claudio E. Raddatz, published in the Journal of Banking and Finance under the title “Authorized participants’ regulatory constraints and limits to ETF arbitrage during market turmoil”. As Raddatz shows based on SEC regulatory data on US bond ETFs, the strength of the arbitrage mechanism dropped significantly during the so-called dash-for-cash phase in March 2020. Before the stress event, a one percentage point increase in the premium led to a 0.69 percentage point increase in ETF share growth, i.e. a strong arbitrage reaction. During the Dash for Cash episode, this reaction decreased by 0.52 percentage points to just 0.17 percentage points. Raddatz attributes this decline primarily to regulatory capital restrictions on APs: for ETFs whose APs were at the 25th percentile of equity ratios, the arbitrage intensity fell by 0.69 percentage points, while for ETFs with APs at the 75th percentile the arbitrage intensity fell by only 0.39 percentage points. Standby APs that had no history of active primary market activity for the respective ETF virtually did not step in during the crisis.
What investors can specifically learn from the stress tests
The March 2020 episode shows the vulnerabilities, particularly in ETFs on less liquid asset classes. Raddatz explicitly documents that the decline in arbitrage was significantly greater for bond ETFs with less liquid underlyings than for ETFs on government bonds with high market liquidity. BlackRock argues in its white paper that the high discounts during the crisis are at least partly due not to real mispricing, but to a latency effect: Since the individual bonds in the underlying index are often rarely traded, the NAV is often calculated on the basis of estimates and dealer quotes. The ETF price, on the other hand, reflects an actually tradable market price. In periods of volatility, the stock market therefore reacts faster than the NAV estimates, which can result in mathematical discounts that do not automatically indicate actual misvaluations.
This results in three specific test points for investors. Firstly, the bid-ask spread in the secondary market: a larger spread between the bid and ask price causes additional trading costs, which can increase significantly in crisis phases. Anyone who buys or sells in such phases should use limit orders instead of best orders. Secondly, the liquidity of the underlying: With ETFs on highly liquid indices such as the S&P 500 or the DAX, premium discount deviations are historically usually small and short-lived, but with high-yield bonds, emerging market stocks and special topics they can be significantly larger. Thirdly, the trading hours: Outside the trading hours of the underlying markets, for example in the case of a US stock ETF in the early European hours of the morning or in the case of bond ETFs in market-poor periods, spreads widen systematically. Those moving larger positions therefore benefit from trading during peak trading hours of the underlying markets, ideally during the overlap of European and US trading hours.
Dominik Maier, editorial team at finanzen.net
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