Special Report: Finding Liquidity Within Policy Benchmarks

The COVID-19 related sell-off in corporate bonds in the first quarter 2020 caused some commentators to express concern about the liquidity and functionality of fixed income exchange traded funds (ETFs) after a financial or economic shock – in particular, corporate bond ETFs.¹

Widening discounts between corporate bond ETFs and net asset value (NAV) pricing after COVID-19 was cited as further evidence of ETF illiquidity. But ETF NAVs use estimated prices for underlying cash bonds, not market trades, and may quickly become stale. In contrast, ETFs trade on exchange daily, and tend to rapidly move to new equilibrium pricing in the face of a shock such as COVID-19. This makes ETF pricing timelier than NAV calculations, as the Bank of England pointed out.²

There is scant evidence the liquidity infrastructure around ETFs, as driven by authorized participants (APs}, failed during the March/April 2020 period - and trading spreads were much narrower in some fixed income ETFs than the underlying bonds.³

Fears around bond ETFs deepened after COVID crisis.

The chart below shows the extent of significant corporate bond spread widening and market dislocation in Q1 2020, in both investment grade and high yield corporate bonds, in the U.S. and Eurozone.

Concerns about liquidity and functionality of bond ETFs are driven by the perceived decline in “market liquidity” in corporate bonds since the global financial crisis (GFC), combined with the growth in assets in fixed income ETFs. The main argument cited has been that corporate bond ETFs are built from corporate cash bonds, which trade OTC in a fragmented market with severely diminished liquidity since the GFC. Hence, it is argued, after a credit event, or market shock, ETFs will become "untradeable" with no liquidity, since if all investors seek to sell at the same time, the underlying securities that compose them will be untradeable. The widening discount between ETF pricing and NAV is also cited as a failure of the arbitrage mechanism designed to keep the ETF price in line with its NAV.

Evidence for this claim is cited as the discount that can appear in bond ETF prices to the NAV of these funds, based on the price of the underlying cash bonds, during periods of market stress. The related assumption is that discounts to NAV on this scale question the validity of bond ETFs as investment vehicles, since ETFs in other, more liquid, asset classes (such as government bonds or equities) have tended to trade much closer to NAV. This discount reached about 5% in some corporate bond ETFs during the March COVID-19 crisis.⁴

Insight: ETF NAVs are not based on intra-day trading prices.

It is noteworthy that NAV pricing for bond ETFs is often based on estimated prices for underlying cash bonds, as trading data may not always be available. Underlying cash bonds may not trade at all on some days, reflecting the fragmented market and diminished market-making since the GFC (it has been estimated the inventory now held by dealer-brokers in corporate bonds is currently less than $60 billion, compared with $418 billion of the inventory held pre-GFC).⁵Nor is there an “official” price for these corporate bonds, with no exchange trading. In the absence of trading data, NAV prices are based on estimates from pricing services.

ETF liquidity is not determined solely by the underlying instruments.

Bond ETF “liquidity” is distinct from the “market liquidity” of underlying instruments. The supply of bond ETF shares can be varied by “authorized participants” or APs – often banks, or institutional investors – who can create or redeem ETF shares in a bond ETF in response to changes in demand for the ETF. This is known as primary liquidity in the bond ETF. Secondary, or on-screen, liquidity is the trading of ETF units that already exist, which drives pricing data, volumes, etc. Overall, liquidity in the ETF will be driven by primary and secondary market liquidity.

一些债券ETF，如高产，具有较差的初级流动性的潜在资产，但这并不意味着在市场震惊之后ETF在二级市场中变得不可能没有。AP的目的是作为投资者和ETF提供商之间的亚缔统治和流动性缓冲，当需求强劲时，创建额外的ETF单元，并且在需求疲软时兑换单位。在Covid-19危机之前进行的一项研究中，并专注于上一期信贷市场压力，英国的金融行为机构发现固定收益ETF流动性在欧洲成为弹性⁶and that lower activity APs acted as alternative liquidity providers, when large ETF discounts appeared relative to NAV.

Authorized participants act as arbitrageurs and market-makers, but there has been no stepping away.

A related concern about bond ETFs is “step-away” risk, where all APs in an ETF step away simultaneously from their arbitrage role in a highly stressed market. The U.S. Securities and Exchange Commission found no evidence in the GFC or subsequent stressed market events of this occurring. Indeed, there is evidence in a recentBlackRock report超过60个资产所有者和管理人员在2020年上半年首次进入了固定收益ETF市场。⁷

Bond ETFs with illiquid underlying securities, such as high yield ETFs, are more likely to trade at wider discounts and premiums to NAV than ETFs that hold government bonds during severe market stress because liquidity in the underlying securities is generally more reliable. This is often described as a “liquidity mismatch” problem. It arises because it may take APs longer to buy the underlying high yield cash bonds to create new ETF units in a rising market, and to sell the underlying cash bonds to redeem the ETF units sold in a falling market, after a shock like COVID-19. There is no evidence that the arbitrage mechanism failed in March 2020. On the contrary, there is evidence of net creation of units by APs during this period, and not redemptions, in some corporate ETFs.⁸

ETF pricing can be a useful guide to new equilibrium pricing on underlying bonds.

相对于VIV的ETF定价的大量折扣和保费​​可以是底层债券价值的有用指南，因为英格兰银行在Q1 2020抛售后结束。⁹Faster price discovery in the ETF should not be confused with mispricing. Instead, this may be evidence ETF pricing has moved to the new, and lower, equilibrium pricing more rapidly, increasing price efficiency.

有两种主要方式波动率可能导致导航较少代表“真实”价格：一个，如果卷较高，昨天的收盘价将从今天的价格远处。如此陈旧的价格比正常更具不准确;两者，在高度挥发性市场中，在任何一天的情况下，甚至更少的潜在债券交易，因此更多的违规价格由估计与硬交易数据组成。

Surge in ETF trading volumes suggests bond ETF liquidity held up well, and trading spreads in many flagship ETFs widened far less than underlying cash bonds.

Trading volumes in both investment grade and high yield bond ETFs confirm there was no suggestion of a freeze in the secondary ETF market in Q1 2020, as the chart below shows.

Some investment grade and high yield ETFs showed volumes more than doubling on a daily basis over March. Similarly, although trading spreads in ETFs widened, iShares flagship ETFs moved far less than spreads in underlying cash bonds, as seen in the chart below.

This is further evidence the liquidity infrastructure around bond ETFs held up well during the crisis, and confirms the diminished liquidity and wide trading spreads in underlying cash bonds. A useful metric for gauging liquidity costs is price liquidity ratio (PLR), which looks at market impact and measures the movement in price of a security for an executed trade of a given size. A higher PLR represents a larger movement in price for a given trade size and therefore shows lower liquidity. The FTSE Russell market price/liquidity ratio in corporate bonds¹⁰在3月/ 4月在3月份售价期间，在4月/ 5月期间，宣布加宽其QE方案以包括企业债券和高产ETF，在4月/ 5月在4月/ 5月的集会期间，展示了明显的恶化。

Institutional investors have policy guardrails, so strategies that acknowledge them are always of interest. II recently sat down withBart Sikora, Director, iShares Portfolio Consulting， 和Brett Talbott, VP, iShares Institutional Team, institutiona如何谈论他们的想法l asset owners might manage their liquidity needs and reduce the hassle of doing so.

We were talking a few weeks ago, Bart, and you mentioned a liquid beta sleeve, which sounds self-evident, but likely is more nuanced. Can you define it for the II audience?

Bart Sikora:Liquidity sleeve is defined as a portfolio of ETFs that attempts to match the most appropriate exposures with the benchmark indices which define a policy portfolio. Policy benchmark is defined as an established asset allocation composed of indices and their weights that is put in place at public and corporate pension plans, foundations, endowments or other entities with investment policy statements. A liquid beta sleeve is intended to deliver the convenience of a strategy that addresses policy benchmark in an investment through index ETFs which are closely aligned with components of the institutional client benchmark. Public and corporate pensions have been most frequent investors. For example, a public pension plan with 70% public market holdings can obtain a close tracking with 0.10%-.25% tracking error for about 0.08-0.15% in management fees.¹¹典型的LBS表示计划规模的3-5％，并且通常旨在精确地匹配基准。当然，LBS可以定制到任何需求 - 而不是与基准密切地对齐，也可以创建它以成为一个补充（即提供与策略基准不同的所需属性）。

Brett, you’ve spent a lot of time thinking about precisely paring the right ETFs with policy benchmarks. What have you discovered?

布雷特·塔尔巴特：通过股权和固定收益可获得的各种β曝光，ETF可允许资产所有者寻求具有各种政策基准组件的合适ETF的精确配对。反过来，我们已经看到了由此产生的ETF基础的流动性套管可以密切地追踪公共资产方面的政策基准，在许多情况下低至0.10-0.20％的跟踪错误。¹²In the most common instance, liquid beta sleeves have been adopted by public and corporate pension plans looking to create a liquidity buffer for their plans that encounter frequent flows. A typical public pension plan allocation is nearly 80% to public assets¹³allowing a very close alignment for a significant portion of a policy benchmark. Corporate pensions have an even greater public allocation. On the endowment side, alternative assets tend to be much larger portion – from 60% for larger plans down to 25% for small plans¹⁴然而，存在一些公共资产代理解决方案，以帮助更好地将经济β接触到ALTS，特别是与坐在多余现金的另一种解决方案相比。

Let’s take a step back – what were the options available to institutional investors prior to LBS?

Sikora：Historically, institutional asset owners took three different approaches. One approach was to keep the entire allocation invested, either internally or with third party managers. This approach led to operational headaches related to frequent benefit payments or other operational needs. A second possible approach kept a portion in cash for near term expenses, but that creates cash drag. The third approach, which is what we've been seeing lately, is ETFs replacing derivatives in strategies. The selection of ETFs now exceeds the selection of derivative instruments, and ETFs may better line up with policy benchmarks, especially in fixed income and international equities. Additionally, investing with futures requires a LIBOR-like rate of cash return for a full total return experience, which can be difficult for some institutional investors to achieve.

How does the liquidity sleeve work in the context of other strategies and managers institutional investors work with?

Talbott:在结构上，平面的一部分被分配给流动性套管，也许是3-5％。通过ETFS进出执行通常是快速的（与贸易日期通知截止日期的T + 1定居点），往往是深入流动性，操作麻烦很低。如果没有流动性套筒，当计划在很大程度上投入外部管理人员时，可能会有频繁和可能的破坏性流动进出，因为该计划缺乏流动性缓冲液。

Ishares可以帮助机构投资者确亚博赞助欧冠定创造流动性套筒方面的最佳行动方案。我们最近推出了一个工具ishares..comwhere an institution can create customized ETF-based portfolios that align with policy benchmarks to get started in building the sleeve. And of course our Portfolio Consulting team can help in this effort.

那么，液体β套的主要目标是什么？

Sikora：伦敦商学院的主要目的是减少tracking error to the policy benchmark (or a comparable institutional benchmark for non-pension clients). As such, an appropriate ETF should be paired with each benchmark index. Matching the right asset class and the right index significantly decreases anticipated tracking error versus cash. Often, pension funds manage their portfolios with tracking error risk budget. With a properly matched up LBS, more of the risk budget can be devoted to the pursuit of alpha and not spent on cash-related tracking error. The LBS structure is intended to manage performance shortfalls in rising markets versus cash.

How has the unending vol of 2020 affected your investment strategy?

Talbott:市场波动中的摄影不可避免地导致更频繁的投资政策违规行为。这些违规可能发生在几个实例中：a）资产重量限制b）历史跟踪误差阈值C）活动风险阈值。与2020年2月的股权卖出的情况一样，许多机构所有者发现自己具有重要的股权体重和固定收入超重。在这一重大的市场中断之前，洛博斯有所领先，允许立即赎回固定收入和股权重量的比例增加。替代方案将慢于物理证券的执行速度较慢，特别是在流动性下降的债券市场中。否则赎回可以在外部经理中进行，并通过通知截止日期和月末通知时间表延迟。