Investors were still able to trade through the market turmoil, just not at the prices they might have hoped for. “If investors wanted that liquidity, they basically had to pay for it,” says Ryan Sullivan, senior vice president of Brown Brothers Harriman’s global ETF services. “They were able to access it. It certainly was not an ideal trade, but all things equal, the funds held up.”
In the underlying markets that the ETFs track, trading essentially froze in many debt securities. That spooked the specialized traders—known as authorized participants—who normally keep a fund’s price aligned with its net asset value. Typically, those market makers will buy shares of a falling ETF to redeem in return for the underlying bonds, which they then can sell. That process reduces the number of shares outstanding and keeps the ETF in lockstep with its holdings. But in March appetite for that arbitrage trade soured as those traders became wary of getting stuck with hard-to-unload bonds.
“They’re not doing this out of the goodness of their hearts,” David Perlman, an ETF strategist at UBS Global Wealth Management, says about the authorized participants. “They don’t jump in until they think they can execute the redemption and make a profit from doing so.”
As the individual securities stopped trading, fixed-income ETFs served as a price discovery tool instead.
“ETFs were actually showing the true value of where fixed income was priced real time,” says Will McGough, chief investment officer of retirement strategies at Stadion Money Management in Watkinsville, Ga. “Because the bonds don’t price themselves—they only price when they trade—they [ETFs] were effectively the supermarket for pricing bonds for a week or two.”
There’s debate within the industry over how to accurately value fixed-income ETFs and their holdings during such a period of stress: Is the true price the net asset value of the underlying securities or the cost at which you can execute trades?
Huszczo compares it to real estate websites that calculate “what our house is worth based off algorithms and comparables.” In reality, he says, “nobody believes that is the actual number. The actual number is just, ‘What is some other person willing to pay for this?’ ”
Opinions about the performance of debt ETFs come down to how investors understand the structure, explains Sue Thompson, who leads distribution of State Street Corp.’s SPDR ETFs in the Americas. “The dislocations happened first in the underlying market,” she says. “If there were not disruptions in the underlying markets, there would have been no disruptions in the ETFs, period,” she says.
Few market participants expect a slowdown in the momentum fixed-income ETFs have developed. The perks simply outweigh the dangers, they say.
For instance, ETFs allow asset managers faced with client redemptions that once would have forced them to sell their most liquid bonds to instead sell a slice of a group of bonds in the form of ETF shares. Their portfolio won’t look drastically different afterward. And ETFs, because they’re so liquid, can be used to park cash until it’s needed to purchase new bonds.