My colleague Russ Koesterich has said it before: Market volatility is the new normal. And when markets are volatile, we see volatility in the prices of exchange traded funds (ETFs). Some investors may wonder if the ETF is simply showing us the market volatility, or if it is actually causing it. Let’s take a closer look.
We know that ETFs trade on the open market. Let’s pretend that we’re monitoring an ETF that is listed in the US but invests in Asian stocks. If we buy that ETF and keep an eye on its price when the Asian market is closed, we can see that the price of the ETF still moves throughout the day, even though the Asian market is closed. That’s because news and information in the U.S. and European markets impacts the value of Asian market stocks, and thus the ETF that holds those stocks. When the Asian market opens again, we see the local stocks move to reflect this new information, and the ETF’s price realigns with the local market. We call this “price discovery”—the ETF is showing you where the market should be priced at a given point in time, even if that market is closed. If all markets are open at the same time, this form of price discovery generally doesn’t take place.
ETFs and Market Volatility
ETFs by nature have created entries into the market that investors wouldn’t normally have otherwise. Some speculate that now more investors have access to markets, there is more trading, and this can actually cause market volatility. We’ve done a lot of research on this and found that ETFs do not cause market volatility. Instead, their price fluctuation is simply exposing already-existing market volatility, adding transparency to the ETF’s price fluctuations. Much like our Asian equity ETF example above, the ETF didn’t increase the volatility of the local market, it just showed you where that market was valued even when it was closed. At the end of the day, a stock is worth what it’s worth and a bond is worth what it’s worth. ETFs are going to trade at a price that reflects where you can trade in the ETF’s underlying market. They simply reflect prices—they don’t cause them to move.
A Look at Bond ETFs
If we shift from stocks to bonds and look at fixed income ETFs, we must consider two things: first, that an ETF is a portfolio that trades intraday; and second, that it’s difficult to see intraday transactions in the bond market. Most investors have difficulty seeing bond price movements intraday; there is no ticker tape you can look to, and most data sources are delayed or hard to access. But if you have a bond ETF, the dynamic changes: The nature of this investment allows you to see price fluctuations intraday.
A great example of this is “Taper Tantrum” that began in May 2013. Interest rates in the U.S. spiked suddenly at this time, and a lot of different bond investments dropped in price, high-yield ETFs included. Investors who were holding high-yield ETFs wondered why the price was falling. A quick look at the high-yield ETF market revealed that other high yield ETFs were dropping in price. If you could look at high yield bond trades you would have seen that they were declining as well. Most investors couldn’t see both the high yield bond market and the ETF market, but if they could they would see that the high yield ETF was reflecting the price drops in individual high yield bond trades. It’s not that the ETFs caused the dip; it’s that their prices simply reflected what was already there, but hidden.
And this is another form of price discovery. The bond market and the bond ETF are both trading at the same time, but one is hard to see while the other is more visible. The ETF helps investors discover what is really happening in fixed income markets throughout the day.