Exchange-traded funds were invented for small investors. Like index funds, which they resemble, ETFs weren’t meant to produce world-beating returns but provide a low-fee, tax-efficient way for small investors to reduce risk by diversifying portfolios. Another selling point is that they’re generally more liquid -- easier to buy or sell quickly -- than mutual funds or index funds. As the sector boomed to as much as $4.6 trillion in the U.S., some worries were raised about whether the fund’s structures would mean that was true in a crunch. Those concerns are top of mind again, now that we’re in a crunch and then some.

1. What’s an ETF and why do people like them?

Mutual funds allow small investors to pool their money and benefit from the expertise of professional money managers. Index funds and traditional ETFs take a different approach. Instead of hiring managers to actively buy and sell stocks, they seek to replicate the performance of a basket of securities (although a small sliver of the ETF market is actively managed). That allows investors who want some emerging-market or small-cap stocks in their portfolio to avoid the cost, hassle or risk of picking individual companies.

2. How are ETFs and index funds different?

Index funds try to replicate the performance of a benchmark like the S&P 500 by buying all the stocks that comprise the index. In an ETF, investors are buying a share in a bundle of the same securities, and that ETF share can be bought and sold much like a share of stock. The ETFs themselves engage in less trading of assets, because the underlying securities don’t have to be bought or sold when a share changes hands. That smaller turnover means a lower tax bill.

3. How big a part of the market are they?

ETFs currently have $3.7 trillion in assets, down from their peak of about $4.6 trillion in February, as investors have pared back holdings in the flight to cash over fears of the economic damage caused by the coronavirus pandemic. Equity funds hold about $2.49 trillion, while those focused on bonds contain $770 billion. The most popular ETFs are the simplest, those that track the broad stock market. But these days ETFs come in thousands of flavors and are popular with hedge funds and institutional investors as well as moms and pops. An increasing number track less-traded markets such as junk debt, use derivatives or heavy borrowing to enhance returns, or laser-in on niche segments of the investable universe. That has made regulators consider whether the more exotic versions need to be reined in lest they damage investors and markets alike.

4. What have they been worried about?

Critics and regulators have long voiced concerns that fixed-income ETFs, whose shares are much more liquid than the assets the funds hold, may exacerbate a sell-off as investors scramble to redeem their holdings during periods of market stress.The likes of Mohamed El-Erian of Allianz SE and Scott Minerd at Guggenheim Partners have suggested they could act as a potential destabilizing force in illiquid credit markets where they have an outsized trading share. After finding that fixed-income ETFs fueled volatile trading during August 2015’s stock-market rout, regulators have long planned to closely watch the funds’ activity and performance during the next downturn. That time is now here.

5. What’s happened in the current turmoil?

Bond ETFs have exhibited signs of liquidity stress, with share prices trading at persistent and deep discounts to the value of the underlying assets. The historical volatility plaguing American bond markets has created unprecedented dislocations in the ETFs that track them and thrown off the market makers who normally step in to repair price inconsistencies. The turmoil led the U.S. Federal Reserve to announce steps to support corporate bonds and eligible credit ETFs. That announcement led to an inflow the same day of over $1 billion to the iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund, the biggest credit ETF, alone.

6. What’s gone wrong?

In theory, the price of all of an ETF’s shares should be exactly the same as the value of its net assets. In practice, it’s not uncommon for what’s known as the Net Asset Value (or NAV) to drop below the share prices, but such small discrepancies are usually quickly wiped away. In normal market environments, such a gap is an arbitrage opportunity for middlemen known as authorized participants. Typically market makers will buy shares of the ETF as its price drops and redeem these shares with the issuer in return for the underlying bonds. The authorized participant will then sell those securities to capture a relatively risk-free profit. By reducing the supply of ETF shares, the fund’s price typically returns to tracking the fund’s net asset value.

7. Why isn’t that happening?

As the coronavirus outbreak unleashes historical turbulence in financial markets and liquidity dries up, ETFs spanning the bond spectrum began trading at steep discounts. Some of the hardest hit were iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD, and iShares 20+ Year Treasury Bond, ticker TLT. That prompted worries that investors scrambling to redeem their holdings would overwhelm the managers, or the traders that channel bonds into and out of the funds -- worries that apparently led the Fed to act.

8. How does this matter to people who don’t hold ETFs?

Some fear that investors rushing to redeem ETFs will exacerbate a sell-off in the underlying market, affecting anyone with holdings in it. ETF investors could lose faith in the products and sell even more, further worsening the situation. Even so, while some ETFs have struggled, they’re holding up overall. A major reason trading remains orderly is that virtually all of the action is happening in the secondary market, between buyers and sellers of ETF shares. Trading in ETF shares, which acts as a liquidity valve in times of stress, has been soaring versus primary market activity, according to Bloomberg Intelligence. The fact that the ETFs are trading at modest discounts to their net asset value may even be a selling point. In a relatively illiquid market, the price of the fund may be the most accurate one the market has got.

For more articles like this, please visit us at bloomberg.com

©2020 Bloomberg L.P.