Did ETFs break down in this latest round of volatility?

Ahmed Farooq, VP of ETFs, looks at how the Canaidan ETF market did during a volatile March.

    What are the current flows and trends for ETFs in March?

    Due to the spread of Covid-19, we are experiencing a black swan event and living through unprecedented times that have brought about renewed volatility for the first time in 11 years. Based on the most recent Canadian ETF Flows Report for March by National Bank’s ETF Research and Strategy team, ETFs overall showed net positive flows of $2.9 billion for the month. It was first time this year equity ETF outsold fixed income ETFs generating inflows of $4 billion. Most of that equity inflow came in the second half of the month with investors buying on the sell offs and to currency hedged ETFs where we saw the US dollar soar against the Canadian dollar. Usually, currency hedged ETF buying is signaled where investors believe there will be a reversal on the US dollar versus the Canadian dollar. There was also a rare negative month for fixed income ETFs, which suffered $1.3 billion in outflows, snapping a streak of 14 consecutive months with positive flows. Most of the outflows came across the board in the Canadian Aggregate, Corporate and in the Government category.

    Debunking the misconception that fixed income ETFs are broken

    Fixed Income ETFs have become a unique case study during this time of volatility. I have fielded a lot of questions on the discrepancy of NAV and the price of fixed income ETFs over the past couple of weeks, there been some helpful white papers and case studies written by the Canadian Capital Market desks and by our own David Mann, who heads up Franklin’s Global ETF Capital market desk: Times of Turmoil and Trouble Keeping ETF Score and The New Normal for ETF Trading.

    Over the last month we have seen the extent of the illiquidity in the underlying bonds. As a result, there has been a misconception that fixed income ETFs are flawed or broken because of how fixed income ETFs have been trading, with some selling at a discount to their Net Asset Value (NAV). The ETF industry has been pretty vocal that this is not a flaw, but actually showing the process of price discovery that is happening in the open market.

    Historically, bond markets have been relatively opaque for some investors. Fixed income has tended to be bought and sold over the counter (OTC). An OTC market is decentralized where buyer and seller agree on a price bi-laterally. An ETF structure not only opens up access to the asset class, but also democratizes its price discovery between buyers and sellers through the exchange. Price discovery mechanism is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. When an ETF is trading below its NAV, it can be normal if the market thinks this is the price the underlying bonds can be sold at. Similarly, this is how a portfolio manager would have to transact in the open market if he or she wanted to sell positions in the portfolio that is currently illiquid, have wider spreads, or haven’t traded at all.

    I believe that the published fund NAV has become stale as the methodology of pricing these individual bonds have never dealt with the current level of illiquidity in the bond market. If you have any questions with how this process works, please reach out and we can setup a call in conjunction with your local wholesaler.

    Please stay safe everyone

    Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns.

    Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

    Ahmed Farooq’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.