How Does Market Volatility Affect ETFs?

In the wake of the increased volatility of the last month, investors and regulators have given renewed attention to exchange-traded funds, or ETFs. When the Dow Jones Industrial Average dropped 588 points on August 24, a top 10 all-time single day decline, some ETFs showed “mispricing”, selling in excess of a 35% discount to their underlying holdings. As volatility has persisted, with the VIX above 20 all month and hundred point daily moves in the DJIA, what do investors need to know about ETFs?

It helps to know the basics of ETFs to understand their recent pricing behavior. ETFs are a sort of hybrid between mutual funds and equities. They are like mutual funds in that each ETF has a net asset value (NAV), which is a per-share price based on the price of the underlying holdings. However, ETFs are unlike mutual funds in that they are priced throughout the day instead of once at the end of the day based on the underlying holdings. ETFs are like equities in this way, being traded at updated prices throughout the day. The fact that arbitrage exists- market makers who offer ETF shares to investors can also redeem their ETF shares for the underlying holdings to be resold, and vice versa- should ensure that the ETF price stays close to NAV.

We saw recently that prices don’t always move in lock-step with NAV. This “mispricing” can happen when big moves occur in the market. During volatility when stock prices have large swings, market makers may set larger bid/ask spreads or even allow a stock to open for trading without a listed price (see NYSE Rule 48). This combines with the fact that ETFs trade like stocks and can be traded with different order types. Investors use sell stop orders to sell shares when trading occurs below a predetermined triggering price, hoping to protect profit or limit loss. Many such orders on the books may in effect say, “sell my ETF shares if the price falls 15%.” As these sell orders are triggered, supply and demand takes over to reduce the price. Investors soon see that an ETF’s price is at a discount to NAV and buy until prices stabilize, but the temporary “mispricing” is valid trading that can occur thanks to algorithmic trading with similar order types.

These price swings in ETFs during volatility bring us back to one of our key principles for investors- know what you own. ETFs have many benefits for investors who invest with a purpose. The low price relative to the underlying holdings makes it easy to create a proper asset allocation, even in smaller accounts. ETFs can be more tax-efficient than mutual funds since ETF investors can choose when to take a capital gain by selling, whereas mutual funds often distribute gains annually. There are many low-cost and commission-free ETFs. Among these benefits, you will notice that creating alpha from intraday pricing fluctuations is not listed. Thanks to arbitrage opportunities, discounted or premium pricing in ETFs is temporary, so passive investors can still take advantage of the benefits of ETFs by sticking to their financial plan during volatility.