ETFs passed the test in the face of increased volume and market uncertainty.
Questions have been pouring in over the past few days as to how market turbulence has affected the performance of exchange-traded funds. The answer, of course, comes in two parts: investing performance and structural performance. In terms of investing performance the answer is quite easy. ETFs are mainly passive vehicles, so they did as well their underlying assets did. Equity-holding ETFs went down, then up, then down, and then up, while gold-holding ETFs just went up and up and up.
From a structural standpoint, ETFs functioned as expected and, in the end, passed the test. Domestic-equity ETFs traded at slightly higher premiums and discounts to net asset value than average, which is expected during times of high market volatility. Commodity, international, and certain fixed-income ETFs saw noticeably higher premiums and discounts, not because these ETFs are broken, but because of certain characteristics of the underlying holdings, which will be discussed below.
Similar to other volatile market periods in the recent past, ETFs experienced a surge in trading volume. The daily trading volume for the top 100 ETFs (which account for about 75% of all ETF assets) was up more than 160% relative to the recent three-month daily trading volume. This increase was greater than the rise in overall trading volume on the New York Stock Exchange. Also, total shares outstanding for these top 100 ETFs fell a mere 0.6% from Aug. 1 to Aug. 9. These two data points highlight the fact that, during periods of market volatility, the liquidity and accessibility of ETFs make them popular vehicles for investors to express their views on the market.
Average Premiums and Discounts
In the table above, we have included the average premium and discount to NAV across four asset classes. The first column is an average from Jan. 1 through July 29 of this year; the second is the average on Aug. 4, when the Dow dropped about 500 points; and the third is the average on Aug. 8, when the Dow dropped more than 600 points. In the U.S. equity space, the large, liquid funds continued to trade, on average, very close to NAV on Aug. 4 but rose to a small average premium of 0.07% on Aug. 8. One possible explanation is that, at the end of the day, market participants were anticipating a market rally on Aug. 9 and were willing to purchase these ETFs at a very slight premium. Small-cap funds, whose holdings are less liquid, did not deviate far from their NAVs, with average discounts of 0.05% on Aug. 4 and average premium of 0.10% on Aug. 8.
Domestic-equity ETFs generally work very effectively thanks to their streamlined structure. Their NAVs are calculated after the market close, and are based on the value of the underlying holdings, whose prices are readily available. The gap between the value of the NAV and the value of the underlying index can be mostly attributed to the expense ratio, and to a lesser degree to tracking error due to sampling and index rebalances. And because the ETF and its underlying holdings trade at the same time, the ETF's price closely tracks its NAV. Any gap larger than the transaction costs would create an easy arbitrage opportunity. However, this structure is not as streamlined in fixed income, international equities, and commodities, which results in higher premiums and discounts.
Scott Burns wrote an article back in 2009 which explained the problem with bond indexes. In summary, bonds, particularly muni bonds and high-yield bonds, are not liquid. In order to calculate the value of the index, matrix pricing is used to estimate the value of the illiquid bonds. During periods of high market volatility, an estimated value of a bond that does not trade can be very inaccurate. Another issue is that, when markets are volatile, bond bid/ask spreads widen, so if there are net redemptions these ETFs will trade at a discount. We think both of these issues contributed to discounts of 200-plus basis points on Aug. 4 and 300-plus basis points on Aug. 8 for iShares iBoxx $ High Yield Corporate