How the Fed programme is impacting ETF markets

Dan Barnes Welcome to ETF TV, I’m Dan Barnes. Joining me today are ETF trader, Paolo Giulianini, and Deborah Fuhr of ETF TV, to talk about the Federal Reserve’s ETF bond buying program and the impact that could be having on the market. Paolo, Deborah, welcome to ETF TV.

Deborah Fuhr Thank you. It’s great to be here.

Paolo Giulianini Thank you.

Dan Barnes So Deborah, can you start off, how would you characterize the Federal Reserve’s ETF bond buying program that started on the 12th of May to date?

Deborah Fuhr Yeah, I would say that clearly the announcement back in March that they were going to buy bonds was a very important statement in terms of giving credibility to ETFs overall, but specifically to fixed income ETFs. There’s always been concerns about, are they liquid enough? Could they handle creations? Could they handle redemptions? And so I think clearly for the first time in its 107 year history, the Fed is buying ETFs and specifically buying fixed income credit and high yield. So I think it’s a real testament to the fact that ETFs actually do what they say they’re going to do, that they are a democratic product being used by all types of investors, including the Fed. And historically, we know that the Bank of Japan has been using ETFs for their quantitative easing program for many years, and own about 70%t of all the assets in Japanese listed ETFs. So I think this is an important statement. And clearly, I’d like to speak to Paolo as an ETF trader to talk a little bit about his interpretation of the buying program. Most ETFs are trading on a secondary basis, so it’s existing shares of an ETF being bought and sold by different players in the market, whereas a primary trade for an ETF would mean, someone is going out and creating more shares. So an authorized participant is allowed to go and trade that underlying basket, it gets sent to the custodian and the ETF gets bigger or conversely, redemption shares come out. Do you have a sense of whether we are seeing primary trades based on what the Fed is doing, or do you think it’s all secondary at this point?

Paolo Giulianini At this point, my idea is mainly secondary, but I think that the more they are getting down the line. definitely they can tap into the primary creation mechanism. I can tell you also why it’s mainly secondary, because the market already tried going outside of the Fed movement, so there’s been a huge creation in those ETFs, both IG and high yield. So the market analysts say is long of this ETF, so they’re happy to facilitate a secondary market trades of those ETFs. So unless the premium of trade in the secondary market will go up for the Fed, it doesn’t make any sense to stop the primary market. So this is a good way for the Fed to have two choices, and at the moment, I would say, it’s the secondary market, because the market is now well long of IG ETF with US underlyings.

Deborah Fuhr That does raise the second question, because you’ve talked about discounts and premiums, so back in March, we were seeing that many of the fixed income ETFs had discounts to the NAV, and that’s really been due to the fact that we often see the NAV is sent at the end of the day. If fixed income securities aren’t pricing all the time, you end up with stale prices. So are you seeing any changes in the pricing of the underlying bonds and premium and discounts in ETFs in themselves?

Paolo Giulianini If you look at the discount and the premium, the corporate bond ETF in the US really moved from a potential huge discount to a potential big premium, compared to a lot of state prices that we have seen even in the trades within the market. So that’s why also the Fed increased the Treasury market program. So now this kind of premium are coming down, and also the spread of Treasury and the spread between high yield and IG is really closing down.

Dan Barnes Given the proportion of the market that’s being traded, as you’ve already explained, is there any impact potentially on liquidity either for long term investors or potentially opportunities for arbitragers with the Fed intervention?

Paolo Giulianini Arbitrage can be between an index fund and MTFs when there are state prices, because you can trade the index fund only vs the official NAV, calculated usually by the custodian or a third party, and the ETF can be traded, as as we said in the secondary market, with light prices provided by the authorized participants. So if you have an index fund that tracks an index that is quite close or the same as one of an ETF, there could be potential arbitrage between the two. The same could be also with a mutual fund. With the mutual fund, the fact that unless it is a closed tracker, that is quite substantial tracking error between the ETF and the mutual fund, so there you can open arbitrage, and even higher potentially. But definitely between an index fund and an ETF, there is a good possibility to open arbitrage. On the other side for ideal arbitrage in this case, you should borrow the index fund, and we know in the market it’s usually not easy to to borrow ETFs for passive index funds. That I think is even more difficult, but definitely there are arbitrage boundaries possible in the market.

Deborah Fuhr I would agree with what Paolo said, I think what we’re seeing is ETFs are more efficiently pricing the value of their holdings than an index mutual fund is. So what you tend to find is you can find very stale prices in index funds and mutual funds. And so there are opportunities to take advantage of that. So I think we’re finding that many investors are realizing that the discount or premium might seem the price of an ETF, it’s actually because it’s more accurately pricing those underlying securities in a real time fashion when the brokers are going to buy and sell. So I think we’ve seen over the past few weeks with the Fed coming in that ETFs have been legitimized as investment products in a greater way, that they feel comfortable with the liquidity creation/redemption process, and that the pricing of bonds has become much more robust. So I think this is a good thing for the ETF industry, a good thing for investors globally, because the more two way trading you get, the better the prices and spreads become.

Paolo Giulianini We have seen in the past some mutual fund that had the real state prices, because only when real redemption came for this mutual fund, then officially NAV moved a lot. So that is something that should not happen, so any issue should be just a function of the underlying securities, not the function of primary market activity in that specific mutual fund.

Dan Barnes I’d like to thank Paolo and Deborah for their expertize, and of course you for watching. To catch up on our other shows, go to ETFTV.NET or TRADERTV.NET.

Published on June 8, 2020