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
Advisors 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 nuances associated with this product versus a mutual fund.
The ongoing market volatility associated with the impacts of COVID-19 has been the first time that the exchange-traded fund (ETF) vehicle has been tested in that ETFs were a smaller and newer offering during the global financial crisis of 2008. Other market stressors since that period (e.g., 2015 flash-crash and 2018 drawdown) were not tied to the systemic malaise associated with crisis. A deviation in the price of a traded product from the NAV would require ETF investors to sell their shares below the value of the actual holdings at a time of crisis, making the vehicle a poorer option than a comparable mutual fund that transacted at the NAV.
Despite this exact scenario taking place in March of 2020 in some of the largest fixed-income ETFs, Cerulli believes that this deviation in NAV should be interpreted with nuance and should impact how both ETFs and mutual funds are positioned to advisors.
For advisors, the takeaway should be that no vehicle is perfect, but that each has unique advantages. If discounts exist in an ETF vehicle offering similar exposure, it is possible that advisors purchasing a mutual fund as a long-term holding are overpaying and would be better served in an ETF. At the same time, investors that do not need intra-day liquidity, but may need to sell at a specific date may well be best served by the mutual fund to the extent that they will avoid some liquidity premium should it become priced in when it is time to sell. While a far more nuanced approach, it is evident that, in crisis, such decisions can indeed impact outcomes and warrant advisor education on the benefits of each vehicle, with the goal of using both in line with the needs of their investors.
ETF Discounts and Bid/Ask Spreads, February 2020 and March 12, 2020
Sources: Morningstar Direct, Cerulli Associates
While ETF trading (and particularly that of equity ETFs) has broadly remained orderly since the markets began to react to COVID-19 in late February, it cannot be ignored that some of the largest fixed-income ETFs traded with increased bid-ask spreads and, at times, significantly below their NAVs. Because Vanguard ETFs are share classes of Vanguard mutual funds, the performance of the approximately $50 billion Total Bond Market ETF (BND) relative to the mutual fund version shows the difference in making the same investment through two different vehicles. On March 12, 2020, ETF investors would have experienced a significant decline of 5.44% as the mutual fund returned a decrease of less than one percent, the same as the decline of the fund’s NAV. While this may suggest that investors in the mutual fund vehicle were better served, Cerulli urges caution in extrapolating from such divergences.
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.