ETFs In Chaos: Shock Absorbers

November 06, 2018

Here’s a big, important point: Both of these were bad days. These were days when the VIX went above 20. The role of SPY here—which is used as a trading vehicle extensively—was to actually absorb demand, in whatever way the market wanted to express it. By putting a bid below the stocks, or an offer over them, I’d argue that SPY’s presence in the market was acting as a volatility reducer, not an accelerator

So let’s look to a different S&P 500 fund, one that we don’t think of as a trading vehicle, but as a buy-and-hold investment: the Vanguard S&P 500 ETF (VOO). While VOO certainly trades well, it’s more notable for being a bit cheaper than SPY (0.04% versus 0.09%) and crushing it in flows lately ($15 billion in new money for VOO, $22.5 billion in outflows from SPY year-to-date).

Here’s the premium/discount over the same window:

 

 

While VOO trades substantially less than SPY, it generally experiences about the same swings. VOO has a slightly lower price, and trades in a slightly tighter band to fair value. What I see on the margin above is quite a few days throughout October where the stocks were oversold versus the price of VOO itself. It vacillates, for sure. And as such, the creation and redemption activity goes back and forth as well.

 

 

Here again, I think we’re seeing the “shock absorber” effect. If the stocks are “oversold,” then APs are going into the market to buy them while selling the ETF; if they’re “overbought,” they do the opposite. The net effect is, again, putting bids under the underlying stocks on the worst days.

Backward Bonds

Is this a perfect analogy for all ETFs in all asset classes? Of course not.

The dynamics of the underlying markets make for a very different story in bonds, for instance, where the ETFs have become the price discovery mechanism. iNAV for a bond ETF, like the iShares iBoxx USD High Yield Corporate Bond ETF (HYG), is inherently fictitious. It’s based on bond pricing services that try and create real-time indicative prices for junk bonds that may not have traded in hours, or even days.

Those pricing services themselves use the price of ETFs as one of their inputs. As such, any perceived premium in the price of a junk bond ETF is in fact just a recognition that the market has moved outside the ability of the pricing services to catch up.

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