Bond ETFs continue to face questions about how they performed when interest rates spiked in May and June on Federal Reserve tapering speculation.
For example, a top-trending story on Monday was BlackRock clarifies ETF ‘true market’ claim from Euromoney.
The ETF industry is “beset by concerns the products are too complicated to be mass market solutions,” according to the article. “However, whether those doubts are justified or overblown remains unresolved. Certainly, it is becoming clear that in periods of volatility … ETFs have become the vehicle of choice for getting out of the market.”
Recent concerns have centered on ETFs tracking less-liquid sectors of the fixed-income market, such as corporate junk bonds and muni bonds. Some of these products traded at discounts to net asset value (NAV) during the May-June volatility. [About Those Bond ETF ‘Discounts’]
Mark Wiedman, global head of iShares at BlackRock, in late June wrote an open letter to investors about ETF performance during this period. [ETF Firms Need to do More on Investor Education]
The financial media has latched onto this line: “More and more ETFs are becoming the true market, particularly when market sentiment shifts fast.”
Wiedman appeared to be writing specifically about ETFs indexed to illiquid bond sectors. [Vanguard: ETF Premiums, Discounts and Volatility]
“In a rapidly moving market, the reported prices of individual underlying assets may become stale. The ETF price can become the true price for that market, and the underlying assets may eventually catch up with any gap between the two,” he added. [ETFs Performed Well in Stressed Market: iShares]
Wiedman elaborated during BlackRock’s second-quarter earnings call when he and BlackRock CEO Larry Fink spoke at length about the recent performance of ETFs.
“What ETFs do is they shine a light on intraday volatility in the underlying asset class, the cash market, the underlying securities,” Wiedman said on the call. “An optical gap can open in the short term versus net asset value.”
NAV depends on historical pricing, or the last known transaction price for the bonds in the ETF’s portfolio, he explained.
“The problem is in fast moving markets, those prices go stale,” Wiedman said.
He noted that in iShares iBoxx High Yield Corporate Bond (NYSEArca: HYG), about 30% of the underling bonds are priced at NAVs that are at least three months old.
Next page: ‘Optical illusions’
“That is the industry convention how we price our ETFs for disciplined conservative valuation practices. But it creates optical illusions versus the underlying cash markets because there are securities in which there haven’t been transactions,” Wiedman said.
The iShares chief did acknowledge the ETF provider needs to do “a lot more work to do in educating clients and other stakeholders about how these vehicles behave, what does the current market price actually represent.”
He also stressed that ETF liquidity depends on the liquidity of the asset class the fund is tracking.
In the bond market, BlackRock CEO Fink said more investors are using ETFs for fixed-income exposure in place of derivatives.
He said the recent bout of illiquidity in the bond market was exacerbated by Wall Street banks facing stricter regulations on balance sheets, leverage and capital.
“We, as long-term investors, are going to have to deal with this. This is why I believe more and more fixed income will be traded on electronic platforms in the coming years and I think we will find a new source of liquidity,” Fink said.
Still, he thinks fixed-income ETFs performed very well during the unsettled markets of May and June.
“There was periods of time during the day where there were appearances of discounts but all that was an indication of where the cash market was going,” Fink said during last week’s quarterly earnings call.
“There is heightened scrutiny of ETFs right now, which I actually believe is a good thing. It’s this type of scrutiny that, in my mind, helps us strengthen the market for the future,” the BlackRock CEO concluded.
“We have a lot of responsibility for the fluidity of this market, for the success of this market. I don’t take that responsibility lightly,” Fink said.
Full disclosure: Tom Lydon’s clients own HYG.