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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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“Surprises” in ETF markets
ETFs
Saxo Group
Summary: Exchange traded funds (ETFs) is created to follow an underlying index or instruments. Generally they follow the underlying benchmark well, but on highly volatile days, some ETFs have been struggling with tracking the performance of the underlying instruments/index correctly, such as for a major oil ETF back in 2020 which caused a temporary trading halt in a major ETF tracking US oil futures. This possible deviance is important to be aware of when trading ETFs on day with high market turmoil.
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.
These tracking errors may become even worse for ETFs tracking derivatives. The rapid decrease of the oil price – even into negative territory – caused a temporary trading halt in the United States Oil Fund LP ETF. The ETF (which cannot trade at negative prices) were suddenly tracking a derivative asset negative, which forced a change in the tracking rules of the ETF. The creation mechanism was suspended for the ETF, keeping only the redemption possibility. As the synergy between the creation-redemption mechanisms were removed, the authorized participant could no longer benefit from the arbitrage, and this resulted in major tracking errors between the ETF and the underlying assets. At the time of writing, the ETF trades at a premium of more than 36 % from their “fair value”! Investors with interest in buying these new lows should keep these mechanisms in mind before investing.
The examples above show that the price of an ETF does not always reflect the value of the actual underlying assets – especially not for leveraged ETFs. With this being said, ETFs still provide a good opportunity to diversify your portfolio at low costs, keeping in mind the risks associated with trading ETFs. And for ETFs which do not track derivative products, these tracking errors are less pronounced.
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