During sanguine market environments when volatility is low and it seems like all assets are steadily appreciating, it’s easy to say that exchange traded funds are behaving as expected.
The real tests come when turbulence spikes and investors are hitting panic buttons. Those are the times when ETFs can truly prove their mettle. Despite what critics may say, nearly three decades of history suggest that ETFs behave as expected when the going gets rough in financial markets.
That’s true of fixed income ETFs, too, which is particularly important for multiple reasons. First and foremost, bond ETFs are growing, and rapidly. Inflows to fixed income ETFs this year are poised to be, at worst, the second-best level on record.
Second, bonds trade over-the-counter. That can lead to inefficiencies in single issues in rocky markets, but during the March 2020 coronavirus market tumult, bond ETFs did their jobs. A recently published report by the International Organization of Securities Commissions (IOSCO) confirms as much.
In March 2020, bond ETFs “traded $720 billion in turnover, but there was only $20 billion in fund outflows, or 2% of total AUM. The volatility shock of March 2020 saw fixed income ETFs trade 36 dollars to every 1 dollar of outflow. Not only is this astounding, but it shows that ETFs helped absorb the shock to the overall system and underlying bond markets,” says Dave Barrer, WisdomTree’s director of capital markets.
As Barrer notes, when financial market stress was high in March 2020, bond ETFs themselves functioned as liquidity buffers. Further proving the mettle of the bond ETF structure, March 2020 wasn’t as kind to fixed income mutual funds, which suffered $250 billion of outflows as managers sought to raise cash, further straining the primary market. How bond ETFs trade is a testament to their utility in times of elevated volatility.
“Furthermore, market makers price in other costs besides the price of the bonds to provide liquidity in the ETF,” adds Barrer. “In times when there is not a lot of liquidity in the underlying market, like we saw in many segments of the fixed income market in March 2020, a liquidity premium in the ETF is being priced in. Investors should embrace this cost as the ETF is providing liquidity that is not present in the asset class they are gaining exposure to.”
Bottom line: Bond ETFs may not provide 100% downside protection during times of heightened systemic risk, but investors can rest assured that these products are likely to function as expected, preventing negative surprises in the process.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.
