Most of the exchange-traded fund (ETF)-related content I have read over the past week has focused on the behavior of fixed income ETFs during this unprecedented time of market uncertainty. I would put that content into two main groups:
- Stale net asset values (NAVs)1:questions as to the true value of the underlying bonds given all the market uncertainty.
- ETFs serving as the price discovery vehicle: the ETF is the “actionable” price, allowing buyers and sellers to transact on exchange for a specific fixed income exposure.
Keep those two points in mind for this discussion on ETF performance (and for now, let’s put to the side the Federal Reserve’s recent announcement it will be buying fixed income ETFs). Usually performance is measured over very specific timeframes such as year-to-date or looking back 1/3/5 years. Exceptions to that happen during extreme market events like we are currently experiencing as investors want to judge how the active management or smart beta methodology compares to the overall market.
For ETFs, there are two main ways to keep score: ETF NAV performance and ETF market price performance. The first is generally the preferred method as it allows for more “apples to apples” comparisons among funds given some ETFs have wider bid/ask spreads and/or trade less frequently, which could cause extra variation with the ETF’s market price.
Valuing Fixed Income
For the first point listed above, keeping score via NAV is going to be problematic right now given current market turbulence and uncertainty. Valuation methodologies put in place have most likely never dealt with the extent of illiquidity currently roiling the fixed income space.
And if there is doubt as to the value of the underlying bonds, then that puts the performance calculations in doubt as well.
So, then maybe we switch to the ETF price in order to measure performance? There are two problems with this method. The first I have talked about in my last post—ETF spreads have widened across the board, and there could be a significant ETF performance difference depending on if the ETF closes near the bid or near the offer.
The second problem is something I also discussed fairly recently. If the ETF arbitrage mechanism is wobbling for a host of reasons, ETFs will trade more like closed-end funds/regular stocks. This means the ETF market price will be driven by buying/selling pressure instead of the price of the underlying assets. Or put another way, two very similar funds can have very different price movements depending on how much buying/selling pressure they receive in the market.
If the usual fixed income ETF rulebook has been tossed out the window, then how are we supposed to compare funds right now? Rather than focusing on short-term performance, I would argue we should turn to something more qualitative: understanding the investment style and objectives of the fund. Is your ETF governed by an index that is only rebalanced twice a year? Or are there portfolio managers selecting bonds based on a dynamic market?
With most fixed income sectors in the red right now, we believe that security selection is what will differentiate how portfolios emerge from this unprecedented market.
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1. Net Asset Value (NAV) represents an ETF’s per-share-value. The NAV per share is determined by dividing the total NAV of a fund by the number of shares outstanding.