ETFs: Passing the COVID-19 Stress Test

by Jason Xavier, Head of EMEA ETF Capital Markets, Franklin Templeton Investments

The coronavirus pandemic has brought validity to what feels like a 30-year initiation for the exchange-traded fund (ETF) wrapper. In the past few months, we’ve seen the ETF ecosystem demonstrate resilience and robustness in continuing to provide clients with the ability to adjust their portfolios intraday and in real time. When we consider the COVID-19 crisis in the context of ETFs, we believe ETFs have done their job as intended across four key areas:

Liquidity: The ETF ecosystem proved that once again even during the third-most volatile period in history,¹ investors were able to successfully source liquidity to adjust their portfolios across both equities and fixed income—moving large blocks of those underlying assets in a single trade. The ecosystem and the participants that allow this to successfully function all worked as intended.

Transparency: The daily transparency of holdings also remained consistent during this volatile period. Where we think the ETF wrapper added additional value was in the transparency around execution. The most volatile days during this crisis saw many underlying markets experience severe dislocations and in some instances a halt to trading. The ability of the ETF wrapper and its ecosystem to continue to accurately price the underlying markets allowed the ETF wrapper to not only identify the cost for liquidity in normal market conditions, but equally, the extra cost for that same liquidity in volatile times was transparent.

Price Discovery: We continue to highlight the ability of the ETF wrapper to provide price discovery as a key benefit for investors from both an asset allocation and risk management point of view. During the crisis, the fixed income asset class was a key beneficiary of this. The ETF’s ability to take a traditionally over-the-counter-driven underlying market and put it onto a transparent trading venue enabled price discovery that had rarely been seen before.

Cost Efficiency: Finally, in terms of cost efficiency, ETFs have substantial cost benefits from the point of view of the total expense ratio. Again, the ETF’s ability to accurately price the underlying basket ensures incoming/outgoing investors accurately pay for entering/exiting a fund independently. Hence, ETFs keep costs independent, efficient and fully transparent, ensuring existing shareholders are not penalised by new investor inflows/outflows. This is important in volatile times, especially if you are a long-term investor not trading in and out of the market frequently.

A Multi-Factor Approach During COVID-19

An increasing number of investors have embraced ETFs, while a new generation of them are already taking full advantage of intentions laid out from yesteryear’s volatile periods. And, we have seen an evolution from straightforward equity and bond ETFs to new niches, including the proliferation of what is known as factor ETFs.

Although initially investors were selling assets relatively indiscriminately when COVID-19 began to spread across the globe, we saw a flight-to-quality kick in. The least volatile stocks and those which were higher quality suffered lower drawdowns than the overall market during the first quarter, which is pretty typical. Investors rewarded stocks with low levels of debt in particular.

In the second quarter, we saw a strong market relief rally, driven mainly by US growth stocks. Growth doesn’t generally perform well after a crisis, so the rally in this area has been surprising. We would have expected interest in value-oriented stocks to return, but over the past couple months we have seen underperformance there.

Within the realm of ETFs in the current environment, it does make sense that the growth factor has done well, considering that the crisis has moved much of our everyday activities online, from education to shopping to working from home. This trend has benefitted the large technology-oriented companies that dominate equity benchmark indexes in the United States and other markets.

We think investors will need a lot more of a confidence in a sustained market recovery before they will be willing to rotate back into the more-battered value stocks, such as financials or energy. In the United States, coronavirus cases are still on the rise, so there’s still some uncertainty there in terms of the state of the recovery.

The timing of factors is always very challenging. That is why we advocate a multifactor approach, wherein an investor can have some diversification and the timing of factors is less crucial. Factors such as quality and low volatility can help investors to navigate volatile markets and momentum can assist in identifying positive investment trends during the period.

One thing that the crisis has highlighted is the classifications of ETFs. Not all ETFs are the same. There is a broad term for exchange-traded products (ETPs), and within ETPs are exchange-traded notes (ETNs) and exchange-traded commodities (ETC), exchange-traded funds and others.

And of course, not all ETFs have performed the same throughout the crisis. For example, there has been a huge divergence between the performance in the different emerging markets, particularly if you compare Latin America with the Asian emerging markets. Many people may not realise China is actually one of the only markets in positive territory this year. We have seen investors beginning to separate their China exposure from their broader emerging market allocations, particularly due to the large size of the market, but also from a tactical allocation perspective.

South Korea has also navigated the crisis fairly well, it has implemented sophisticated tracking systems to keep the virus contained, and on the fiscal side, the country went into the crisis with a relatively low level of debt. South Korea is also a key player in the global technology space, leading developments in disruptive and innovative technologies. So, we’ve seen many investors take a greater look at the opportunities in the South Korean equity market and vehicles like ETFs focused on South Korea have thus seen more interest.

On the flip side, Brazil has been a different story. Its economy and market have been struggling. Financials and energy are a big part of Brazil’s market, and these two sectors were negatively impacted. The coronavirus experience has also been pretty acute in Brazil, with high levels of cases and deaths. Investors can thus tilt towards equity markets where there’s more potential opportunity, and can do that with a low-cost, efficient emerging market single-country ETF.

We believe the ETF landscape will continue to evolve so that the classifications for different segments will be even more defined and differentiated, allowing investors the ability to be more precise in their allocations while still utilising all of the well-tested benefits of the ETF wrapper.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

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1. Source: Bloomberg. The third largest single-day decline for both the US and European equity markets was March of this year; only the 1987 and 1929 crashes were greater.

This post was first published at the official blog of Franklin Templeton Investments.