ETFs not only survived—but thrived—one year into pandemic

March 25, 2021 | Expert Perspective

ETFs not only survived—but thrived—one year into pandemic

David Sharp

David Sharp
Senior ETF Capital Markets Specialist

Key highlights

  • ETFs delivered critical liquidity during periods of market volatility.
  • ETF bid-ask spreads were a fraction of those for their underlying securities.
  • Bond ETFs served as shock absorbers.
  • Despite volatility, ETFs posted positive cash flows.

ETFs played a critical role in providing liquidity

It's hard to believe it's been a year since the height of volatility caused by the COVID-19 pandemic. As markets have settled, it's a great time to reflect on the stability ETFs provided in a time of uncertainty. The ETF ecosystem proved resilient, enabling investors to transfer risk in a cost-efficient, orderly manner while playing an important role in providing liquidity.

ETFs proved to be resilient

Although bid-ask spreads widened for ETFs during March 2020 as volatility enveloped the market, ETFs still fared considerably better than the underlying securities in their portfolios. Bid-ask spreads for an ETF's underlying securities (basket spreads) are typically wider than the ETF spreads. At the height of the pandemic-related volatility, this relationship held, proving the cost efficiency of the ETF structure.

The table below shows how bid-ask spreads for two of Vanguard's flagship ETFs, Vanguard S&P 500 ETF (VOO) and Vanguard Total Bond Market ETF (BND), remained significantly narrower than the spreads for the underlying securities throughout the pandemic-related volatility.

  Vanguard S&P 500 ETF Vanguard Total Bond Market ETF
Spreads during volatility 3 bps 2 bps
Spreads prepandemic 1 bp 1 bp
Basket spreads during volatility 11 bps 51 bp
Basket spreads prepandemic 4 bps 17 bp

Source: Bloomberg.

Notes: The table shows the average of daily bid-ask spreads, in basis points (bps), for two Vanguard ETFs® during the peak period of volatility (February 24, 2020, through April 9, 2020) and before it (January 1, 2020, through February 21, 2020). A basis point is one-hundredth of a percentage point.

Industry ETF bid-ask spreads were a fraction of the spreads of their underlying constituents

Industry-wide this dynamic also held true—especially for bond ETFs, even during the heightened volatility of March 2020, as ETF spreads remained only a fraction of basket spreads.

U.S. equity ETFs, spreads from January 2 to April 17, 2020

The illustration is a line chart showing the average spread of U.S. equity ETFs compared with the average spread of their corresponding baskets of underlying securities for time periods leading up to, during, and after the COVID-19-related market volatility in early 2020. In each time period, the average spread for the baskets of securities was wider than the average spread of the ETFs. The chart shows that spreads for both the baskets and the ETFs widened slightly in March but began narrowing in April.

U.S. fixed income ETFs, spreads from January 2 to April 17, 2020

The illustration is a line chart showing the average spread of U.S. fixed income ETFs compared with the average spread of their corresponding baskets of underlying securities for time periods leading up to, during, and after the COVID-19-related market volatility in early 2020. The chart shows that the U.S. fixed income ETF average spread stayed at a relatively narrow level throughout the volatility in March, while for the average spread of the corresponding baskets of securities widened significantly. Spreads for ETFs remained narrower than spreads for the baskets at all points, and spreads for both began narrowing in April.

Source: Bloomberg.

Note: The average of daily spreads for each time period weighted by notional trading value is plotted for U.S.-domiciled equity ETFs  (the first figure above) and U.S.-domiciled fixed income ETFs (the second figure).

COVID-19's impact on ETF premiums and discounts

In normal market environments, ETFs typically trade at a modest premium or discount to net asset value. However, during March 2020, discounts on some ETFs were significantly greater than historical norms. This dislocation was most apparent in bond ETFs and was driven by many factors, including a sharp decline in liquidity of the underlying fixed income securities, increases in transaction costs of those securities, and nuanced differences in valuation models used by pricing vendors (reflected in ETF NAVs) and market makers (reflected in ETF market prices).

During periods of market volatility, divergence between an ETF's market price and NAV is more likely, particularly for bond ETFs. In fast-moving markets this includes changes to the cost of providing liquidity.

The modest premiums typical of fixed income ETFs that were observed in early 2020 gave way to relatively large discounts in mid-March, as a result of a steep drop-off in the liquidity of the underlying securities, which led to an increase in the price of liquidity for bonds. These discounts quickly reverted to premiums by early April, demonstrating that although discounts can be unsettling, they tend to be short-lived.

Average premiums and discounts for bond ETFs, January 2 to April 17, 2020

U.S. fixed income ETFs with more than $1 billion in assets under management

The illustration shows the average premium or discount for U.S. fixed income ETFs for various time periods in early 2020. At the beginning of the year, the ETFs started with a small premium of 6 bps, which became a small discount of 6 bps in late February and became a larger discount of 172 bps during the height of market volatility in mid-March. By late March, the discount had decreased to 33 bps, and the ETFs were back to having a small premium in mid-April of 19 bps.

Source: Bloomberg.

Note: The figure shows average daily premiums and discounts for U.S.-domiciled fixed income ETFs that had more than $1 billion in assets under management.

Bond ETFs served as shock absorbers

Fixed income ETFs are generally more liquid than the underlying bonds that make up their portfolios. If not for the liquidity available through bond ETFs, there likely would have been much more selling pressure on fixed income securities in the primary market at the height of the market volatility in 2020, highlighting the critical role of the ETF structure.

Because much of ETF trading occurs on the secondary market with little to no direct impact on the underlying securities, ETFs act as shock absorbers—particularly during periods of market stress like in March 2020. Overall, an average of 79% of U.S. fixed income ETF transactions took place on the secondary market from July 2019 through June 2020.

Most trading in fixed income ETFs occurred on the secondary market

U.S. fixed income ETFs—Secondary-market ratio

The illustration is a vertical bar chart that shows the proportion of secondary-market trading relative to all trading of U.S. fixed income ETFs that occurred from July 2019 to June 2020. The percentage of secondary-market trading in any given period varied from approximately 65% to 95%, with the average being 79% overall.

Source: Bloomberg.

Notes: The figure shows secondary-market trading volume as a percentage of total notional trading volume for all U.S.-domiciled fixed income ETFs. The baseline is the average of secondary-market transactions.

Looking to the future

Throughout the volatility caused by the COVID-19 pandemic, the structure of ETFs allowed them to remain a powerful tool for investors of all types. ETF spreads remained narrower than those of their underlying securities, and bond ETFs allowed you to buy and sell even when the bond market seized up.

The clearest vote of confidence for the resiliency and flexibility of ETFs, especially bond ETFs, was demonstrated through the record cash flows experienced since the height of the volatility in March 2020.


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