/Here’s how to think about the turbulence in ETF pricing, and here’s what to do about it

Here’s how to think about the turbulence in ETF pricing, and here’s what to do about it

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Exchange-traded funds are a great tool for investors

Markets have experienced stomach-churning swings since late February, and exchange-traded funds have struggled to keep up. ETFs, including some of the biggest, most high-profile funds on the market, have traded at prices that appear out of whack with the underlying securities that comprise them.

For the ETF industry, the fact that the funds are trading at all, including through the worst market dislocations since the 1987 market crash, means they’re doing what they were engineered to do. For critics, it means the worst fears about ETFs are coming true. More important, though, may be the question of what kinds of guardrails may be put in place to buffer against these kinds of dislocations in the future.

Read: ETFs, born from 1987 market crash, are so far making 2020 less awful

Most of the pricing hiccups over the past few weeks have taken place in “illiquid” corners of the financial markets — those that aren’t easy to trade. As MarketWatch has reported, that has included bonds of many types, most of which trade very rarely. It’s also starting to include ETFs that invest in foreign stocks, sources confirmed to MarketWatch on Wednesday.

There were about 700 ETFs trading at a price that was at least 1% or more higher or lower than that fund’s Net Asset Valuation, according to a report provided to MarketWatch by a source.

ETFs rely on big institutional players called “Authorized Participants” to keep an equilibrium between the price of the fund and those of the underlying securities. Bonds sometimes trade infrequently, and foreign stocks are bought and sold on markets that may be closed when the U.S. markets are open, and vice versa. Those strains are only exacerbated during times of severe financial stress, like the past few weeks.

“I’m in the camp that they’re working just as designed,” said Reggie Browne, a principal at ETF market maker GTS. “They are a clear reflection of the underlying marketplace that they represent.”

The value of the funds are “ALWAYS slower than market price, in the best of times,” said Dave Nadig, chief investment officer and research director for ETF Flows. “What we’ve done now is massively accelerate time. The current environment is bananas. So things like ‘daily valuations’ have become quaint throwbacks to horse and buggy era trading.”

While ETFs may seem to be keeping up better with markets in real time, “there’s definitely a broader sense of confidence in the financial markets that comes to bear,” said Gregg Gelzinis, a senior policy analyst at the Center for American Progress.

“The fact that this mechanism and structure are breaking down a little bit can add to fear and contagion in other markets,” Gelzinis told MarketWatch.

To be sure, Gelzinis doesn’t think ETFs are fatally flawed. Just like mutual funds, ETFs have advantages and disadvantages, he said, but until now they had never been tested in a severe, lasting downturn. “I think a lot of people were treating ETFs like mutual funds that can trade all day.”

The market turmoil of the past few weeks, Gelzinis said, “shows that we need to re-think the regulatory structure around ETFs.” That may include a more explicit “buyer beware” kind of warning to would-be investors that such a pricing dislocation may take place, he said.

But Browne thinks there’s already plenty of disclosure available to investors considering buying an ETF. Instead, he said, bond pricing needs to be made more modern and transparent. The market needs to aggregate all the various sources of bond pricing into one source so the best bid and offer are captured, with that information being made freely available to all interested investors via a service like Yahoo! Finance or Google, including a ticker, just like stocks have.

It should be just as easy for any investor to trade a bond at the pricing he or she sees in real-time as it is to buy or sell a share of Amazon stock, Browne said. “If you want to trade Amazon or some other equity, you can put a market order in and almost guarantee a fill at that price.”

Implementing such a market structure would be a “huge lift,” Browne acknowledged, but would help increase confidence in the market.

As an aside, ETF industry participants like Nadig have long been evangelists for investors using limit orders, not market orders, to buy and sell ETFs, even in relatively calm markets. The turbulence of the past few weeks only highlights that idea.

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