Coronavirus crash puts ETFs under pressure, but sector proves up to it
Kanish Chugh
The spectacular market slump and price dislocation experienced over February and March put the stock market under stress; but the exchange-traded fund (ETF) sector was perhaps more closely watched than others.
The sector came through with a strong pass mark – although it came under pressure from extreme market circumstances.
“The primary task of an index-tracking fund is to basically give investors the fall – and rebound – of their underlying indices, and overall, the broad index-based ETFs have done this,” says Kanish Chugh, co-head of sales at ETF Securities.
ETFs exhibited some volatility in pricing in line with the volatility or the structural setup of the underlying assets and indices. Volatility was more pronounced in some asset classes. But no Australian-listed ETFs closed or were unavailable for their primary activity.
“We saw a sharp spike in activity, as more investors realised that they could use the ETF market in a much more varied way than they may have thought – for buying, selling, hedging and tactically trading, whatever they wanted to do, in a variety of asset classes,” says Chugh. “Activity in February and March showed that Australian investors are increasingly comfortable with using ETFs to express their investment views.”
According to Chugh, spreads on many ETFs were wider than usual during the heightened coronavirus-driven volatility but this only reflected the extreme market movements in underlying exposures.
He points to the largest global equity vehicle in the Australian market, the iShares S&P 500 ETF.
The spread jumped to 15 basis points (0.15%) in March from an average spread of 4 basis points (0.04%) in February. This reflected the fact that on several occasions in March, the US stock-index futures, which market-makers base their pricing on, stopped pricing. This was a result of futures falling more than 5% and going ‘limit-down’ meaning they are not allowed to move any more.
“This ‘gapping risk’ is possible and it was borne out in March, but the market-makers still maintained pricing on the ETFs,” says Chugh. “Now, that’s their job, but it does involve them using their modelling techniques and doing everything they can from their side to accurately reflect the prices, and take that risk on to their balance sheet. But they were able to give investors the ability to buy or sell on the ASX.”
“If the bid/offer spread on any index widens, that of an ETF based on it will react,” says Chugh. “Say it’s the MSCI Emerging Markets Index, and the spread surges from 30 basis points (0.3%) to 90 basis points (0.9%), you would expect a tripling of the ETF’s spread too, at a minimum. This is what the ETF is meant to do,” says Chugh.
This situation was repeated in many ETF sectors and asset classes during the coronavirus crash, when price discovery was suddenly made very difficult. In some of the fixed-income sectors such as corporate bonds and high-yield bonds, market-makers also had to take balance-sheet risk to maintain a buy-sell spread as prices gapped, and this pushed spreads wider.
“Whenever spreads widen, it’s because of the difficulty of price discovery in the underlying assets,” says Chugh.
“We saw the market-makers – which are firms that are some of the biggest buyers and sellers of bonds in the world, and they are probably better-placed than anyone to understand what the prices are of some of these fixed-interest products – take risk on their balance sheets to maintain a market. And in those cases, we then see the ETFs actually providing a more accurate reflection of the pricing than the underlying market is providing,” says Chugh.
What gratifies ETF issuers the most when reflecting on the February-March market turmoil was the strong vote of confidence represented by investor activity. The number of transactions, and volume and value figures, reached all-time highs, according to Chugh.
“The ASX ETF sector on average traded about $770 million a day – that’s nearly four times the high of the previous peak. The 748,000 transactions for March was about two-and-a-half times higher than the previous month. There were a lot more people being more active in the market, because the versatility of ETFs allowed them to do what they wanted to do,” he says.
