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BlackRock clarifies ETF ‘true market’ claim

As heavy outflows, product withdrawals and confusion over pricing vex the ETF industry, BlackRock softens its claim that investor demand had made ETFs the ‘true market’. It’s unclear whether the problems are a blip or a more serious threat to the products.

It was a classic case of turning a good news story into a PR disaster. When Mark Wiedman, global head of iShares, wrote an open letter to investors at the end of last month extolling the incredible liquidity of exchange-traded products (ETPs), initially he seemed to be making a simple observation regarding the growing popularity of tracking products.

However, Wiedman took his argument one step further. So dominant were exchange-traded funds (ETFs) in terms of liquidity, he said, that they no longer followed the market, but were the market – the implication being that no longer do ETFs track underlying baskets of securities, but vice versa.

The philosophical problem created by that assertion is that investors buy ETFs and ETPs to get access to particular asset classes that represent risk exposures to corporate capital structures, commodities or other investments with measurable real world prices, against which the ETP can be benchmarked.

If now the ETP becomes the benchmark, then how can its price be evaluated?

Unfortunately for Wiedman and BlackRock, owner of iShares, the purported role-reversal came at the end of a month of extreme volatility, during which some $8 billion had been withdrawn by investors from ETPs, amid disturbing evidence that the products no longer seemed to price in line with the securities they were tracking.

In one example, the $221 million SPDR Nuveen S&P High Yield Municipal Bond ETF hit a discount of 4.8% to its underlying.

These two factors, alongside a disturbing trend of ETPs being launched and quickly withdrawn, combined to introduce additional doubt into an industry already beset by concerns the products are too complicated to be mass market solutions.

However, whether those doubts are justified or overblown remains unresolved.

Certainly, it is becoming clear that in periods of volatility – the VIX index of US equity market implied volatility spiked from 15 to 24 in June – ETFs have become the vehicle of choice for getting out of the market. Providers ascribe this to the instruments’ Delta 1 characteristics – derivatives that lack optionality – which they say far exceed comparative mutual funds.

“Over the recent period, we have seen incredible flows into ETPs and also more volatility, but in general we do see prices settle very quickly back in line with the underlying,” says MJ Lytle, chief development officer at London-based Source. “Of course in some markets, for example fixed income, there can be some confusion over what the right price of the underlying is, and that has to do with price discovery.”

The problem for investors is that price discovery on some securities is somewhat opaque, and can be complicated by out-of-hours trading or illiquid markets. Some hedge funds have looked to exploit those opportunities, trading ETFs against the underlying securities where they believe the ETF is mispriced.

Providers recognize this problem and BlackRock, in the wake of Wiedman’s letter, have looked to clarify the mechanics that lead to mispricing, pointing to the natural arbitrage that arises when an ETP is mispriced, and which can be quickly closed by the actions of dealers creating or redeeming ETF shares for profit.

They have also rowed back on Wiedman’s claim that ETFs are the true market.

“If you look at the market capitalization of the US equity market, then the assets under management (AUM) in ETPs tracking that market is relatively tiny,” said Ursula Marchioni, a member of the iShares EMEA investment strategies and insights team.

“So then if the question is does ETP pricing lead the underlying, the answer is no. However, if there are niche markets where the relative sizes are closer, these are dynamics we want to investigate.”

A complicating factor is the behaviour of dealers, which do not necessarily create and redeem ETF shares at the same rate as shares traded in the secondary market.

That can lead to mismatches in price behaviour, and during the sell-off in June, some leaders were left holding shares as investors bolted, causing, for example, the price of the iShares iBoxx $ High Yield Corporate Bond Fund to dip below the NAV.

As investors come to terms with the uneven dynamics of ETF pricing, another issue highlighted in recent weeks is the number of products that have failed to gain traction.

Out of some 1,600 ETPs in Europe last year, around 1,000 have AUM of less than $50 million, according to Source’s Lytle. The problem was evidenced in June when db X-trackers closed 36 products, citing lack of investor demand.

“There are a lot of similar products out there, and that is a challenge,” says Deborah Fuhr, a partner at research firm ETFGI. “For example, there are at least 36 ETFs referencing the Euro Stoxx 50, so we are seeing firms rationalizing where there are cross listings.”

With funds closing, questions over pricing and disturbing outflows during periods of volatility, providers are facing an uncomfortable period of self- examination, in what might be the beginning of a period retrenchment for ETPs.

Another explanation, however, is that it’s a well-timed reality check on the continuing march towards ubiquity.

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