Ill-judged mudslinging against ETFs has resurfaced, says CIO, who tells WP he is shocked at the level of misunderstanding in the investment community
Tyler Mordy is president and CIO of Forstrong Global Asset Management. As the coronavirus crisis continues to take hold, ETFs have come under renewed fire for causing systematic risk. A frustrated Mordy reached for his laptop to defend the ETF structure and explain why it’s once again proved its innovative ability.
Here we go again. Another spike in volatility, more spreading of misinformation about ETFs (as if the virus wasn’t enough).
Where to start? First, we have used ETFs as portfolio-building tools since 2003. Forstrong was the first asset management firm in the world to embrace this financial technology to build globally diversified portfolios. It has been an extraordinary ride and clients have benefitted enormously from portfolios that can only be described as more diversified, more modern, and, ultimately, more resilient.
With that preamble out of the way, ETFs have repeatedly come under attack for causing systemic risks. Over the years, we have responded to many of these criticisms. At times, it has felt like playing whack-a-mole. The same criticisms surface, and we always provide the same answers.
The fact of the matter is that ETFs have proven their durability through several crisis episodes. Most notably, 2008 was a serious stress test. Guess what? The ETF structure passed with flying colours.
Or consider 2014, where we were interviewed by the National Post about bond ETF illiquidity. Again, a period where the ETF structure was durable and emerged victorious.
In the current coronavirus crisis, mudslinging has surfaced again. And again, misinformation has gone viral. In fact, we are shocked at the widespread level of misunderstanding in the investment community itself. Many stock pickers believe that ETFs are “forced sellers”, allowing them to pick up steeply discounted individual stocks.
This view represents a complete lack of understanding of ETF mechanics. ETFs do not define trends; they are designed to follow them. That is why they are called “trackers” in Europe. What’s more, most of the ETF trading occurs on secondary exchanges which does not impact liquidity of the underlying securities. If anything, stock pickers should target mutual funds, which can in fact become forced sellers.
Turning our attention to the current situation surrounding bond ETFs, the right perspective can be found if investors understand two issues:
- The reliability of the net asset value (NAV)
- The liquidity of bond market itself
Determining the NAV on bond ETFs, particularly those with corporate bond exposure, has become extremely difficult as portions of the bond market have effectively been frozen from trading during the recent market turmoil.
When bond ETFs trade at a discount to NAV, market makers can make risk-free arbitrage profits by buying ETF units, redeeming them in exchange for the underlying bonds, and then selling those bonds. Market makers will continue this process until the ETF is trading back in line with its NAV, and no further arbitrage opportunities exist.
In the current environment, market makers have been reluctant to execute this arbitrage process. This effectively suggests they are not confident in the ability to sell the underlying bonds for more than they paid for the ETF units. Accordingly, the large tracking error of bond ETFs in recent days is much more likely a case of overestimated NAVs than an issue with the ETF structure itself.
A secondary issue around NAV mispricing comes from the bond quotes themselves. As several of the bonds being quoted to calculate have not traded in days, the price becomes stale which means the NAV becomes stale. If the bonds were to actually trade one would witness the NAV quickly come back in line with the price of the ETF. In essence, the price of the ETF is showing the market where these bonds would trade if they did trade. This is called price discovery.
Regardless, bond ETFs have provided a critical source of liquidity for investors during this difficult period. As the bond market has seized up, bond ETFs have actually been the best source of price discovery for the underlying market. This is financial innovation at its finest. And, it shows why the smart money continues to enthusiastically embrace the ETF vehicle.