When it comes to liquidity, there are few investments easier to jump in and out of than exchange-traded funds (ETFs). Think of them as a nice cool pool on a hot day. (Note: We’re sweltering in Toronto, so I had to get something cool in here somewhere!)
In the pension space, where liquidity is king, ETFs have become a much-used tool for transition management. They’re also used as liquidity “sleeves,” to give plan sponsors a bit of wiggle room for when they need cash fast.
ETFs have been especially compelling for their ability to get investors in and out of less-liquid areas of the world, such as emerging markets.
The thing is, liquidity can come at a price when markets go nuts, which is exactly what happened in the wake of Federal Reserve Chairman Ben Bernanke’s now-infamous May 22 remarks about pulling back stimulus in the U.S. His remarks sent shock waves through global markets, with emerging markets bearing the brunt of the sell-off.
ETFs in particular took a beating—as emerging market stocks hit one-year lows, share prices for the 10 largest diversified emerging market ETFs were, on average, 42.6% more volatile than their underlying indexes between May 22 and June 24, according to Bloomberg. Share prices for many ETFs hit their biggest discounts for the year against the published value of their holdings, or the net asset values of the underlying assets.
In an open letter to investors, BlackRock’s Mark Wiedman pointed out that ETFs are increasingly becoming the “true market,” especially when market sentiment shifts and volatility is the order of the day. As that happens, it creates a lag between the price of ETFs and the underlying shares, which will be slower to catch up and close the pricing gap.
So while ETFs deliver liquidity few other investments are able to offer, investors need to mind the gap between the price of ETFs and the underlying shares when volatility hits—especially in smaller markets.
The key lesson? Liquidity, yes—but during times of extreme volatility it can come at a price. And as ETFs become a bigger and bigger force in global markets, these kinds of price disjunctures could become a bit more common as investors flee to cheap and liquid ways to invest. (In fact, right now, in this heat, I’d pay big bucks for a cool pool in my backyard!)