What happens when fixed-income ETF prices deviate from the NAV in a crisis?
Performance of ETFs and mutual funds in tumultuous markets underscores benefits to using both vehicles in concert
Advisor concernsAdvisors express concerns that a key drawback to their use of fixed-income exchange-traded funds (ETFs) was the possibility of a deviation in the price of the traded product from the net asset value (NAV) of the fund during periods of market volatility. This deviation, which has occurred several times in March 2020, illustrates the importance of educating advisors about the distinctions between this product versus a mutual fund.
Paying for liquidity
ETF Discounts and Bid/Ask Spreads, February 2020 and March 12, 2020
Sources: Morningstar Direct, Cerulli Associates
Why do ETFs fall below the NAV?
There are several explanations for ETFs falling below the NAV during the latest period of market stress. At the highest level, ETF trading is supported by market makers and authorized participants who need to ensure that their activities are profitable and will add a margin of safety, resulting in lower ETF prices and investors effectively paying some price for access to liquidity. This was in exceptionally high demand as the Dow dropped by 10% on a day referred to as Black Thursday.
Another, but related, explanation was offered in a blog post by Dave Nadig, which explored the challenges of properly valuing the fixed-income securities priced into the NAVs that index providers and pricing services calculate. As fixed-income liquidity has declined over time, it has become more difficult to have confidence in the valuations of some of the underlying bonds—often achieved via marking to model. This practice can add to the margin of safety added by market makers, but it is also possible that by having capital at risk, market makers can be ahead of the curve in pricing the underlying bonds.