The UK’s capital markets have lost $500bn (£445bn) in value in September alone, according to Bloomberg. Among the worst performing funds throughout that period were bond ETFs, especially leveraged gilt ETFs. For example, Wisdom Tree’s 10-year, three-times leveraged Gilt ETF is down more than 55%
this year.
Funds offering passive exposure to linkers have also been punished. The iShares Index Linked Ucits ETF had fallen almost 40% by the beginning of October with Vanguard’s Inflationlinked Gilt Index fund down -27%. Corporate bonds have also been affected. For example, the sterling-denominated iShares core Corporate Bond Index ETF is down more than 24%, year-to-date, according to Morningstar.
Net inflows
But the paradox is that unlike the broader market and despite often poor performance, ETFs still enjoyed net inflows. In the weeks prior to the Bank of England’s intervention, there was a notable surge in inflows into gilt ETFs to £96.54m for the week commencing 14 September, followed by £1.6m in inflows the week after, according to Lipper.
This ties into a broader trend. The European ETF industry also benefited from €1.3bn (£1.1bn) in inflows for August, despite their assets falling to €1.28trn from €1.31trn in July, according to Lipper. This drop in assets was largely due to a fall in the value of the underlying markets, the data provider said.
Meanwhile, bond ETFs attracted some of the biggest inflows of €5.2bn (£4.5bn). “Given the general market environment with rising interest rates, it was somewhat surprising that bond ETFs enjoyed inflows for the month,” noted Lipper’s monthly ETF fund flow report.
Globally, investor appetite for bond ETFs has increased, according to the September Asset Allocation survey by Bank of America Merryl Lynch. It remains to be seen whether this trend will also be reflected among UK institutional investors.
Appetite for liquidity
One potential explanation could be growing investor appetite for liquidity in increasingly volatile markets. But this raises the question how reliable open-ended funds like ETFs are when it comes to facilitating the ease of buying and selling assets.
Systemic risks from open-ended funds, including ETFs were a key focus of the IMF’s latest financial stability report. Open-ended funds now hold $41trn (£36trn) in assets, with ETFs accounting for more than a quarter of that, according to the IMF.
“Open-ended funds holding illiquid assets can worsen fragility in asset markets through the liquidity mismatch between their asset holdings and liabilities,” the report said. “In the face of adverse shocks, open-ended funds that offer daily redemptions to investors but hold relatively less liquid assets are vulnerable to the risk of investor runs (or large outflows) that could force these funds to sell assets to meet redemptions. The sale of assets could in turn generate downward pressure on asset prices that may amplify the initial effects of the shocks by inducing additional redemptions.”
When comparing asset price fragility of open ended funds in general to that of ETFS in particular, the IMF concluded that other open ended funds showed higher levels of asset price fragility than ETFs. This is because investors are generally not able to redeem shares at net asset value. Instead, they are traded on secondary markets at varying prices. But the IMF also showed that ETF discounts tend to increase when market liquidity deteriorates as they continue to be traded.
However, advocates of ETFs as providers of market liquidity would point out that the open-ended nature of those funds allows them to issue an unlimited number of shares to be traded in the secondary market, even if the primary market dries up. A case in point is Russia’s stock exchange, where primary markets closed at the start of the invasion of Ukraine, but investors continued to trade in secondary markets.
But in practice, this endless supply of liquidity is still dependent on authorised participants stepping in and creating those shares. So far, they appear to have done so, even in extreme events of market volatility, such as the crisis in gilt markets seen in September. The test will now be whether they will also stand the test of monetary tightening, a concern which is now high on the IMF’s agenda.
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