March 25, 2021 | Expert Perspective
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.
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|
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-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.
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.
U.S. fixed income ETFs with more than $1 billion in assets under management
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.
U.S. fixed income ETFs—Secondary-market ratio
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.