Exchange traded funds (ETFs) are deemed to be one of the most important innovations of the financial markets in the last decades. Institutional and private investors alike are offered a tremendous variety of exposures to different baskets of Equities, Bonds, Commodities and even derivative instruments. Within the different categories, investors can expect broadly diversified portfolios that they can easily invest in on most exchanges, taking on and giving up risk almost instantly. But one should not forget that the inherent liquidity provided by this instantaneous nature does come with a caveat, a “side effect” one would say, of increasing the fungibility of otherwise less liquid assets in the capital markets. This side effect is not unknown and stems from the simple disconnect of liquidity in the market for ETFs and their assets. If they were assumed to be simple wrappers for the baskets they represent, no inherent mechanism would keep speculation on share prices for the ETFs from pushing prices far away from the value of the underlying assets (net asset value, or NAV). Evidently, such an event is not purely hypothetical, as, for example, Seth Klarmann illustrates with canned sardines and the Spain Fund in his famous 1991 book "Margin of Safety". If such an event happens on a grant scale, effects are not to be underestimated.
A disconnect in fungibility, among other factors, was what largely made banks struggle in the Great Financial Crisis when bubbles formed in the liquid market for derivatives on less liquid Mortgage Backed Securities that eventually blew up. As such, what is it that keeps speculation in check when ETFs can be freely traded in any market whereas the same is not the case for underlying assets like bonds? The answer to the question is Authorized Parties, or APs, which provide a limited but efficient way of handling the arising arbitrage opportunities for ETF issuers. The majority of those Authorized Parties are established Securities Trading desks who are already trading the assets contained in the funds for which they act as APs. In case that shares of an ETF exhibit a premium to the net asset value trading desks buy shares of the fund in the market, exchange them for the underlying basket of securities and subsequently sell the securities in the market to rid themselves of the risk on their books. The arbitrage mechanism for fund shares exhibiting a discount follows the same procedure, just backwards. The AP buys the basket of securities in the market, and issues an ETF share, thereby effectively compressing the spread. At this point it is important to notice that the AP is not required to act as arbitrageur. It can therefore choose whether a certain spread is worth the risk of having all the associated securities on its balance sheet until they can either be exchanged (in case of a premium) or sold off (in case of a discount).
In very liquid markets the associated risk might be small, since bundles of securities can easily be gotten ahold and sold off – depending on the individual securities even in higher volumes. Problems start arising once APs operate in less liquid markets, or markets that are subject to big shocks connected to sudden spikes in volatility. Under those circumstance it becomes riskier to keep the basket’s securities on the balance sheet and traders will demand a higher risk premium – or spread respectively. Such a situation occurred recently during the first days of major sell-offs connected to the spread of Corona virus when – according to the Financial Times – one of Vanguard’s bond ETFs traded at a discount of 6% to its net asset value on March 13th (Lex, 2020). But as recent research concludes, illiquid markets for underlying assets are not the only reason for premia and discounts. As (Pan & Zeng, 2019) shows, Balance Sheet Constraints of the aggregate of all APs also lead to temporary discounts or premia, particularly in the presence of bond flow shocks to their balance sheets. This means that – for example – in a scenario where an ETF is discounted to NAV, should the aggregate of the APs experience a large, positive shock to its bond portfolio, they would not be able to perform arbitrage on the ETF, as this would require taking additional bonds on their balance sheets. In this regard, the regulation of trading firms seems to influence the occurrence of mis-pricings.
Overall, the phenomenon of discounts or premia in ETF prices is no indicator of a general issue with them. Under normal market conditions they do not pose a threat to either private or institutional investors as these anomalies are quickly resolved and only occur in extreme market environments. Looking at what happened to the derivative market for MBS during the Financial Crisis and connecting it with ever tougher regulation for trading desks and rising ETF volumes the issue could become more pressing over time.
Tobias Schmidt
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A disconnect in fungibility, among other factors, was what largely made banks struggle in the Great Financial Crisis when bubbles formed in the liquid market for derivatives on less liquid Mortgage Backed Securities that eventually blew up. As such, what is it that keeps speculation in check when ETFs can be freely traded in any market whereas the same is not the case for underlying assets like bonds? The answer to the question is Authorized Parties, or APs, which provide a limited but efficient way of handling the arising arbitrage opportunities for ETF issuers. The majority of those Authorized Parties are established Securities Trading desks who are already trading the assets contained in the funds for which they act as APs. In case that shares of an ETF exhibit a premium to the net asset value trading desks buy shares of the fund in the market, exchange them for the underlying basket of securities and subsequently sell the securities in the market to rid themselves of the risk on their books. The arbitrage mechanism for fund shares exhibiting a discount follows the same procedure, just backwards. The AP buys the basket of securities in the market, and issues an ETF share, thereby effectively compressing the spread. At this point it is important to notice that the AP is not required to act as arbitrageur. It can therefore choose whether a certain spread is worth the risk of having all the associated securities on its balance sheet until they can either be exchanged (in case of a premium) or sold off (in case of a discount).
In very liquid markets the associated risk might be small, since bundles of securities can easily be gotten ahold and sold off – depending on the individual securities even in higher volumes. Problems start arising once APs operate in less liquid markets, or markets that are subject to big shocks connected to sudden spikes in volatility. Under those circumstance it becomes riskier to keep the basket’s securities on the balance sheet and traders will demand a higher risk premium – or spread respectively. Such a situation occurred recently during the first days of major sell-offs connected to the spread of Corona virus when – according to the Financial Times – one of Vanguard’s bond ETFs traded at a discount of 6% to its net asset value on March 13th (Lex, 2020). But as recent research concludes, illiquid markets for underlying assets are not the only reason for premia and discounts. As (Pan & Zeng, 2019) shows, Balance Sheet Constraints of the aggregate of all APs also lead to temporary discounts or premia, particularly in the presence of bond flow shocks to their balance sheets. This means that – for example – in a scenario where an ETF is discounted to NAV, should the aggregate of the APs experience a large, positive shock to its bond portfolio, they would not be able to perform arbitrage on the ETF, as this would require taking additional bonds on their balance sheets. In this regard, the regulation of trading firms seems to influence the occurrence of mis-pricings.
Overall, the phenomenon of discounts or premia in ETF prices is no indicator of a general issue with them. Under normal market conditions they do not pose a threat to either private or institutional investors as these anomalies are quickly resolved and only occur in extreme market environments. Looking at what happened to the derivative market for MBS during the Financial Crisis and connecting it with ever tougher regulation for trading desks and rising ETF volumes the issue could become more pressing over time.
Tobias Schmidt
Want to keep up with our most recent articles? Subscribe to our weekly newsletter here.