Lessons learned: On volatility, liquidity and ETFs

Michael Lane |2 juin 2020

As the world continues to grapple with the coronavirus, the economic and market implications are still far from clear. We may be entering a “new normal” where in the foreseeable future the only certainty appears to be uncertainty. However, for investors, new ways of thinking about the markets and how to manage portfolios have emerged in recent weeks. These, I believe, are likely to be with us even in a post-corona world.

The crisis has not changed the basic cardinal rules of investing — for example, stay diversified, understand the risk you can tolerate, define your goals and measure your success relative to those goals, not just your rate of return, but the ways of following those rules are evolving. I’ve been working with financial advisors for nearly thirty years and have seen over the years how the most successful have repeatedly adapted to changing market conditions, technological advances and new financial instruments, particularly exchange traded funds. But nothing compares to the changes I’m seeing now.

ETFs have become indispensable in both analyzing the market, as well as a valuable tool to address a number of challenges that investors face. For example, ETF flows can reveal market sentiment, and the price of the ETF can provide insights into the cost of underlying assets that may be illiquid at the time. ETFs can then be deployed in a range of ways to express views about a particular asset class or to strengthen a portfolio.

The trading statistics underscore this increased reliance on ETFs. Average daily trading volumes in Canadian-listed ETFs increased from $1.4 billion a day in 2019 to $4.1 billion a day during March 2020, roughly a 189% increase. Single security volume in Canada also increased, but by only half that of the ETFs, roughly 95%.1

Who are these new ETF users? Institutional investors often pave the way for investing innovations that are later adopted by financial advisors, and this is no exception. Many ETF usages were first utilized by institutions, but even in this instance many institutions are turning to ETFs like never before.

But so are financial advisors. Why? The answer is simple: Throughout the recent market volatility, ETFs provided liquidity for investors to trade across a range of asset classes with low costs, efficiency and insight into the real time prices of the underlying securities.

Against that backdrop, I’ve been spending a lot of my time at home speaking with advisors. I’m always asking, “What are you doing to help your clients stay disciplined in these times, while adapting to unprecedented stresses and volatility?” Here are the main themes I am hearing:

Focus on rebalancing, not market timing. Financial advisors are well aware that trying to time the bottom or top of a market is extremely difficult. It’s human nature to try and forecast market movements based on the information we know today. But it’s been proven repeatedly to be extremely difficult, with most winners being what you could statistically expect from random chance. A better approach is to simply try to stay on course with the investors’ asset allocation. During the selloff, an average investor in a hypothetical “60/40” portfolio of 60% stocks and 40% bonds — the classic benchmark allocation for a representative portfolio — at one point, and in very short order, became a 51/49 portfolio. With the market rebound over the last couple of weeks, it is now more like a 54/46. Still, a drift from your asset allocation means the investor has moved away from the risk he or she is willing to take to meet long-term goals. As Armando Senra discussed recently, research from the 2008 crisis showed that simply rebalancing the hypothetical portfolio back to a target asset allocation when the portfolio moved more than 5% outperformed those who didn’t by 1.77%.2 This is not a new lesson: Clients of advisors who practiced disciplined rebalancing during and after the 2008/2009 Global Financial Crisis fared far better than those that fled to cash or tried to time the market. It’s a proven successful practice.

Look to a liquidity exposure. Here is a more recent phenomena that has surfaced during the recent market stress that I learned from my institutional colleagues. Once the advisor sees the need to rebalance the portfolio, the next question is how to implement that change. In the most recent crisis that most likely meant buying stocks and selling bonds. If the portfolio is holding mutual funds and/or individual bonds that could lead, however, to a wrenching dilemma: Do I sell a fixed income mutual fund that I like with a good manager, or do I try to sell individual bonds in a market where the liquidity had dried up? And when I say “dried up,” I’m not exaggerating. There were an unprecedented number of bonds that simply were not trading, which meant for many institutional and retail investors there was difficulty creating liquidity from their fixed income exposures. In some cases, the portfolio may have only held a limited number of securities that could be traded, and the impact of selling a concentrated amount of more liquid bonds could leave the portfolio mispositioned. Some would suggest just holding a large cash reserve, which gives investors options but also can crimp returns. A potentially better solution: Hold a portion of the portfolio fixed income exposure in ETFs, which helps you stay invested in the market, but also provide a diversified source of liquidity to buy or sell when the need arises. That could mean, for example, supplementing your high yield investments with a high yield ETF like iShares U.S. High Yield Bond Index ETF (CAD-Hedged) (XHY). But it isn’t just high yield that was difficult to trade during this market stress — investment grade corporates, and even some government bonds were difficult to price. The ETF creates a liquidity exposure, potentially easier to trade, when the need arises.

Choose the right vehicle. Advisors are turning to ETFs for a range of uses, recognizing the flexibility and efficiency of the vehicle. They can be used for core positions like broad domestic or international equities, or fixed income. They can be utilized for tactical asset allocations on specific sectors, industries and countries. They offer price discovery into the underlying assets, are low-cost, and as the current crisis has shown, their liquidity in times of market stress can be invaluable.

Throughout my conversations with advisors and my institutional colleagues in recent weeks, we are all struck by how the much the world is changing, and not just because we are all working from home, but also how ETFs are helping improve the ability to manage portfolios of all sizes.

Michael Lane
Head of iShares U.S. Wealth Advisory, BlackRock