Secondary Trades
Secondary trading means there always should be a market. When an ETF’s price falls below the value of its holdings, sophisticated traders step in to buy the discounted ETF shares and swap them for the underlying securities. The traders can then sell those securities at the higher price, earning an arbitrage and bringing the price of the ETF back in line with its value.
The world’s largest junk-bond ETF, the iShares iBoxx High Yield Corporate Bond ETF, sees about six shares trade in the secondary market for every share that’s created or redeemed on an average day, according to Bloomberg Intelligence. In times of market stress, that ratio can spike as high as 20 to 1.
ETFs “absorb market activity as underlying bond trading recedes,” BlackRock Inc., the world’s largest issuer of ETFs, said in a paper last month.
Flash Crash
Not all U.S. bond ETFs are created equal, however. Though three of them trade more than $1 billion shares a day, half see turnover of less than $1 million. While ETFs are designed to meet redemptions with securities, funds that own leveraged loans or overseas debt usually hand out cash, tempering the arbitrage opportunities that keep fund values in line with their holdings.
“When someone wants to look at an ETF very specifically for liquidity-management purposes, of course they should look at how actively traded that particular ETF is within that sector,” said Stephen Laipply, head of fixed-income strategy for BlackRock’s U.S. ETF business.
Even the structure itself isn’t bulletproof. During the flash crash of Aug. 24, 2015, market makers on the exchanges found themselves unable to price ETFs as futures contracts went dark, and hundreds of ETFs temporarily stopped trading after the resulting volatility triggered exchange limits. In June 2013, Citigroup Inc. stopped redeeming ETF shares for clients after hitting its internal risk limits. Last year, two banks stepped away from a cannabis ETF after it changed custodians.
Tighter balance sheets in the wake of the financial crisis have also encouraged some banks to scale back ETF trading. Electronic brokers have stepped in, but fears remain that they could back away in a volatile market, leaving funds to trade at a discount. Investors would still be able to sell, just not at the price they might like.
“To say this is a foolproof mechanism,” Deshpande said, “let me just say, it needs to be tested.”
This article was provided by Bloomberg News.