Sam Huszczo had long been a skeptic. Exchange-traded funds, already wildly popular among equity investors, were emerging as a cheaper, easier way to build a fixed-income portfolio than investing in a mutual fund. But after a decade-long bull market, no one could be sure how the new products would perform in a downturn. Would they exacerbate turmoil in their underlying markets?
Finally, near the end of 2018, the founder of SGH Wealth Management in Southfield, Mich., decided to give them a try, investing about 27% of the firm’s assets in the funds. Throughout 2019, things seemed to be working well, Huszczo says. Then the coronavirus became a global pandemic, plunging stock and bond markets into a downturn.
Huszczo, like so many other money managers who overcame trepidations and piled into the new market, could only watch as the record volatility that plagued U.S. bond markets in March led to share prices of bond ETFs trading at deep discounts to the value of their underlying assets. On March 23 the Federal Reserve said it would buy corporate debt and eligible ETFs and then expanded the program weeks later to high-yielding securities to keep credit flowing.
“Everything was in a free fall until the Fed stepped in,” says Huszczo, who turns 39 in July. “No one likes to see their bond portfolio go down like that.”
By early May, with that big assist from the U.S. central bank, the consensus was that fixed-income ETFs had—for the most part—passed their first big test. But it was a roller-coaster ride along the way.
After years of sluggish growth, ETFs that track corporate or government debt last year took in more than $150 billion in the U.S., the most on record and just short of the sum attracted by equity ETFs. That’s boosted total assets to about $858 billion, or roughly 21% of U.S. ETF assets, data compiled by Bloomberg Intelligence show.
Critics and regulators have long voiced concerns that fixed-income ETFs, because they’re much more liquid than their underlying assets, would exacerbate price declines when investors scramble to redeem their holdings during periods of market stress. Mohamed El-Erian of Allianz SE and Scott Minerd at Guggenheim Partners are among veteran investors who have suggested ETFs could act as a destabilizing force in illiquid credit markets where they have an outsize trading share. (El-Erian is a Bloomberg Opinion contributor.)
When U.S. stocks fell more than 30% in March during the worst sell-off in history, bond ETFs showed signs of liquidity stress. Some of the hardest-hit were the Vanguard Total Bond Market ETF, or BND, and iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD.
In one notable example, on March 12, Vanguard’s BND was down 3.8% year-to-date, while its mutual fund counterpart—the Vanguard Total Bond Market Index Fund—was up 2.7%. The prices have since reunited, with both funds up about 3.7% so far this year as of May 11.
Dorian Garay, a New York-based portfolio manager for NN Investment Partners, says that such a divergence in prices during a period of stress limits the value of fixed-income ETFs for some investors. “The potential problems of investing in ETFs are related to risk management, as you cannot actively manage your risk exposures,” he says.