“Surprises” in ETF markets

Investing in an exchange traded fund (ETF) gives a broad exposure to a number of stocks and other financial instruments through a single instrument at relatively low costs. They are traded on exchanges similar to stocks. ETFs are good instruments for diversifying your portfolio, thus reducing the risk if a single company are hit by a bad streak or reports bad earnings.

As stated by one of the major ETF providers in one of their ETF descriptions, their ETF “aims to track the performance of the xxx index”, with no guarantee that the ETF will yield the same return as the underlying assets. This difference between the ETF and the underlying index is denoted the “tracking error”, and many investors are not aware that ETFs are not a direct 1:1 replicate of the returns in the underlying benchmark.

In the volatile markets in March 2020, where liquidity disappeared in many European ETFs, market makers spreads widened dramatically [Link – to liquidity article]. As an example, the average bid-ask spread in percentage terms peaked during the month at 3.1% for an ETF tracking inflation-linked government bonds. The tracking error during this period increased significantly, and the ETF traded with a 4 % discount to the actual value of the underlying assets. In some cases with ETFs tracking corporate bonds the ETF price may go well below the fund’s net asset value because the underlying prices on the corporate bonds are uncertain or maybe rarely updated.