Big market sell-offs can be very unnerving, even for the most seasoned market veterans. Too bad the truth can be a casualty of market volatility too.
Unfortunately, sharp sell-offs can also lead to the creation of false narratives that exacerbate the confusion many investors feel during periods of market turbulence.
Yesterday was perhaps the worst day for global asset markets since 2011 or even 2008. Everything from bonds to commodities to equities dropped, and there wasn’t a single region that was immune from weakness.
When these things happen, people look to point fingers. It’s a natural human response to try and make inferences, and it’s a natural product of our 24-hour news cycle to try and pinpoint the exact cause of every market move.
Whether the market is up or down, pundits point to a specific news story or economic release, often in ways that wrap the day’s market action into a tidy little sound bite or summary.
I get it. This is their job. Their editors, their producers and their managers are telling them to do this and to do it faster and better than the next guy. Unfortunately, this can lead people to draw conclusions about certain market dynamics or misinterpret non-news as news.
All of this is a long-winded way of saying that the two Financial Times posts from this morning—one that talks about “plumbing” problems in ETFs and another that wonders aloud whether ETFs are leading the market sell-off —were about as inaccurate and misguided as any we’ve seen in quite awhile.
The first article implies that somehow the sell-off in the market has disproportionately affected ETFs and their issuers. This conclusion, besides being sensationalist, ignores many of the fundamental nuances of the ETF wrapper.
For example, the author points to the iShares MSCI Emerging Markets Index Fund (EEM) trading at a 6.5 percent discount to indicative net asset value (iNAV) as some indication that the ETF structure failed.
By simply mentioning this discount without providing context, the author leads the reader to believe this is some sort of newsworthy—perhaps even apocalyptic—development. In fact, the author mentioned that dealers were struggling to keep up with sell orders, and somehow maps this statement to the discount in EEM.
The problem with this path of (il)logic is it ignores the basic principles of EEM’s portfolio. Seventy-eight percent of EEM’s holdings don’t trade during U.S. market hours, meaning during any U.S. trading day, more than three-quarters of EEM’s iNAV (78 percent) is made up of stale prices and 22 percent is based on live prices.
As such, it’s a nearly worthless gauge of the real-time value of EEM’s portfolio during the U.S. trading day. Any premium or discount that appears during the U.S. trading day is actually the ETF providing price discovery, and in doing so, provides an invaluable service to market participants.
This basic reality, of course, has nothing to do with dealers being overwhelmed by sell orders, but it has everything to do with systematic capital markets weakness.
With or without an ETF tracking Brazil, emerging markets or Sweden, the market would be repricing assets in those countries at lower levels based on their interpretation of the global capital market action that day.
The fact that the ETF tracking those markets may be trading at a discount to a worthless value print (iNAV) doesn’t mean “ETF plumbing” has been clogged in a crazy day of trade. In fact, the opposite is true:The ETF is reflecting the depressed prices investors are placing on the assets from those countries where real-time prices are unavailable.
Perhaps more reckless is the claim, in the second article, that ETFs are leading the sell-off in the market and some ETFs have become larger than the markets they track. Both statements are equally ludicrous, but not as inane as the claim that somehow the market sell-off is based on “ETFs’ general over-reliance on arbitrageurs bridging the gaps.”
One of the first things any finance course will teach you is arbitrage pricing theory.
Sure, there are exceptions to the rule—especially in hard-to-access markets with uneven prices. But every asset in the world is priced by some variation of arbitrage theory. To speculate that ETFs over-rely on arbitrage is missing the point of ETFs and their structure entirely.
Again, the fact that EEM swung to a discount of 6.5 percent yesterday is a nonstory. And to conclude that the discount arose from some disruption in the product or similar ETFs is, frankly, reckless.
Pointing to the fact that Citi stopped accepting redemption orders to support some fantasy about fractures in the ETF facade is a leap of faith too far for Carl Lewis.
The saddest part is there was actually an interesting story hidden in both articles.
The fact that State Street Global Advisors halted cash redemptions in favor of in-kind? Now, that’s a story.
Actually, the fact that SSGA’s SPDR Nuveen S'P High Yield Municipal Bond (HYMB) has traded at a big discount of 10 percent is news. When you connect the dots between the two, you realize it’s not the ETF structure that’s failing, but rather the bond market itself.
The bigger takeaway is the reminder that when liquidity dries up, the least liquid assets trade at the most distressed prices.
This, of course, is of paramount importance considering the way investors have been herded like cattle into the most obscure, opaque pockets of the capital markets in the quest for yield.
Since the high-yield municipal bonds HYMB holds are significantly less liquid than, say, the 500 stocks in SPY, it stands to reason that in periods of market stress, the market for HYMB’s holdings will dry up in a heartbeat.
When liquidity is deep and the market is rising, SSgA is more than happy to do redemptions in cash because it would have little trouble offloading the underlying bonds. When the opposite is true, the fund sponsor would rather let authorized participants (APs) hassle with trying to find buyers for the bonds in the redemption basket.
In other words, when liquidity dries up, SSgA has no reason to absorb the risk of finding trading partners for the illiquid bonds.
At the same time, APs are going to pass along the cost of selling those bonds to investors in the form of quotes. They’re going to quote shares of the ETF far enough away from iNAV to compensate themselves for the cost of selling those bonds into a falling market.
Again, this isn’t an “ETF plumbing” issue. This is a liquidity issue that underscores how important it is for investors to understand the assets they own and the markets that govern them.
Unfortunately, stories like that require some logical follow-through that can be quite the headache when you’re on deadline.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at email@example.com.
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