Over the past few years, a common question from investors and advisers has been: How will ETFs perform during a GFC like market event? Well, now we know.
The question isn’t about performance, rather liquidity and spreads.
The ETF’s performance is a function of the exposure it provides, such as the top 500 S&P ranked companies in the US or the top 200 S&P ranked companies in Australia. If they are collectively down, then so is the ETF.
Liquidity and spreads are a function of the vehicle the portfolio is delivered in and ETFs are proving themselves in the current market in comparison to their nearest peers: LICs and LITs.
LIC’s and LITs are only required to post their Net Tangible Assets (NTA) on a monthly basis (some provide weekly updates). An ETF, on the other hand, publishes its Net Asset Value (NAV) every second.
The reason for the glacial pace of LIC/LIT reporting is because they are closed end funds. This means that once the units are issued there is no way of redeeming them. To exit a position, an investor needs to find someone willing to buy it from them.
ETFs are different, being open ended. Thus, if an investor wants out, they simply sell their unit to a market maker who then proceeds to hand the unit back to the issuer. The issuer then sells the underlying holdings at market price and the cash goes back to the investor.
This makes a big difference, particularly in volatile markets. LICs & LITs can trade at large premiums (rarely) or discounts (commonly) to their NTA, because investors don’t really know what they are worth and also have to find someone willing to buy from them. In a market like this, there aren’t a lot of investors piling in to LICs/LITs and with prices whipping around, who knows the fair price? As a result, swathes of LICs & LITs are currently trading at big discounts.
ETFs rarely stray far from their NAV because it’s calculated in real-time and could therefore be arbitraged if it moved too far away (eg; if an ASX200 ETF was trading at a big discount, arbitragers could buy the ETF and sell the 200 stocks, then reverse the trade when prices converge and make a profit).
LICs & LITs make sense for investment portfolios that hold illiquid assets and therefore can’t quickly redeem their assets. However, many simply hold liquid shares or bonds.
Not to say ETFs are perfect. As the market has bucked and tumbled in recent weeks some ETFs have traded below their NAV and spreads have widened. This has mainly been afflicting fixed income (bond) ETFs as some of their holdings have frozen in the current market, meaning the ETF has been difficult to price.
Finally, human nature enters the equation in the form of incentives. LICs and LITs are legally allowed to pay brokers and advisers a stamping fee for new issues, so vendors are incentivised to sell these products to investors.
ETFs have no such incentive, so they have to prove themselves by offering attractive exposures, performance and fees.
If you were buying or selling a listed portfolio in this environment, which structure would you prefer?
Disclaimer: Please note that these are the views of Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice.
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