Exchange-traded funds are the weapon of choice for many investors confronted with coronavirus induced market volatility.

Data from ETF provider BetaShares shows that while the industry contracted in February, as share prices fell sharply towards the end of the month, trading value reached a monthly record: more than $7 billion traded in Australian ETFs for the first time.

The high volumes mirrored trading patterns in ETFs globally, the provider said, with investors seeking out the liquidity of ETFs during volatile times to express both bullish and bearish views.

Morningstar's director of global exchange-traded fund research Ben Johnson says he's not surprised to see investors of all stripes flocking to ETFs in this market – particularly in the fixed income market.

"ETFs are a dynamic investment wrapper," he says. "They can be used by long-term investors as low-cost, tax-efficient portfolio building blocks.

"They have penetrated actively managed funds as a means of maintaining market exposure and managing liquidity needs.

"They can be sold short by those with a bearish view.

"And they've become an additional layer of liquidity in fixed-income markets, stepping in where traditional bond market participants have stepped out in the post-financial-crisis period."

The top performer for February was the ETFS Physical Palladium ETC (ASX: ETPMPD) gaining 23 per cent, followed by BetaShares’ Strong Bear Hedge Fund Products, (ASX: BBUS) (U.S. Equities) and (ASX: BBOZ) (Australian Equities).

Buyer beware

But as investors pour into ETFs, they should do so with care, says Morningstar senior fund analyst Matthew Wilkinson. Bid/ask spreads are widening dramatically across the board as volatility spikes.

"We are now amid one of the most volatile and illiquid trading environments we've witnessed," Wilkinson says.

"This may give investors reason to be active in markets, especially if rebalancing due to significant price falls in equities relative to fixed interest or cash allocations.

"However, spreads have widened across the board, which makes this a market environment when correct trade execution of exchange-traded products, or ETPs, is paramount."

ETFs trade like stocks on the exchange, explains Johnson. "Investors pay or receive the going market price for their shares. Prices tend to hew closely to the value of their underlying assets. ETF market makers make sure of this. They are the linchpin of the ETF ecosystem. They quote bid and ask prices for ETF shares and compete with one another to profit from any discrepancy between the funds' share prices and their own estimates of the value of the funds' assets."

Johnson explains that in normal market conditions, market makers face little risk and ample opportunities to collect profits from keeping prices in check and pocketing bid-ask spreads in exchange for connecting ETF buyers and sellers. But these aren't normal conditions.

"Today, the risk market makers face has flared and the demand for their ability to price them has peaked," he says.

"As a result, they are having greater difficulty and facing bigger risks pricing ETF portfolios and are quoting wider bid-ask spreads."

Wilkinson warns that poor execution can wipe out a year's worth of returns, or more.

Morningstar has written extensively on how to best trade ETFs during periods of volatility. Each time they write, they update the message to be more succinct and simplify how to avoid big mistakes and provide insight into recent issues. Here is Wilkinson's latest list of do's and don'ts when trading ETPs in volatile market environments.

If you need a quick refresher on NAVs, iNAVs, premiums and discounts, read this first.

Trading exchange-traded products — best practice

Matthew Wilkinson, senior manager, funds research, Morningstar Australasia

  • Check the spread and market depth.This is most relevant around the open and close, but also when markets are volatile. For global products, liquidity should be viewed before any trading, as the underlying holdings may not be trading during Australian Security Exchange open hours and consequently spreads may be wider than usual. This is particularly critical when U.S. equity futures are fluctuating meaningfully, a common occurrence right now. If you see unusually wide spreads, then:
    • Having to cross the spread can be very costly, so be patient. Market makers and other market participants can skew the spread, meaning the net asset value, or NAV, may be far closer to one side of the spread than the other. Take, for example, an ETP that has been under significant selling pressure. The NAV might be $0.50, the best bid could be $0.44 while the best offer could be $0.52—maximum risk is taken by both sides wishing to cross the spread.
    • Remember that you can also place an order inside the quoted spread and it still might be met. If in doubt, you may also be able to contact the product issuer to arrange the trade.
  • We recommend using limit orders wherever possible. These are orders at a specific price and removes the risk of getting filled at multiple prices that can be costly in illiquid markets. Particularly risky is using a market order that is larger than the volume on the first available price, as it will get filled at successive prices until the whole order is filled. We have seen liquidity fall substantially in the current market environment across ETPs, and this can mean getting filled across prices that may span 1.0% or more, which is very costly. For very large and liquid ETPs, market orders can be less problematic if spreads are narrow.
  • Investors should use ETPs with a long-term mindset to avoid being tempted into excessive trading and the mistakes that often come with it, particularly if one crosses a widespread. A short-term outlook only increases the likelihood of an unsatisfactory result. This statement is never truer today—a well-constructed portfolio should need little tinkering, only rebalancing, when the time is right. The more often ETPs are traded, especially during times of uncertainty, the more likely there are going to be costly mistakes.
  • We don’t recommend using stop-losses for ETPs, particularly in illiquid markets. They can be executed at inopportune times, for example, when spreads are wide, and prices are at potential lows. Furthermore, they are not particularly necessary for long-term investors. In these situations, price alerts may be a better option.

Where once we said that "checking the iNAV (intraday NAV - net asset value) on the asset manager’s website" was an important step, we now think it can be less useful and even misleading at times. We’ve observed market prices and spread midpoints well away from iNAVs, particularly for those managers who aren’t incorporating the change in futures markets, like Magellan's Global Equities ETF (ASX: MGE) and Global Equities Currency H ETF (ASX: MHG). During calmer markets those iNAVs may be more reliable.

In summary, if you’re looking to place a trade, select a price that you’re happy with, and send a limit order to the market. Those who are buying when markets are under pressure can afford to be patient and stand further back from current prices; while those who are selling may need to select a price more aggressively. However, investors should be conscious that prices can move violently in either direction.

For those who are eager to trade, an option may be to enter multiple orders at different prices to increase your chance of getting at least some filled. Whatever the method, volatility can offer opportunity, but investors need to be aware of the market environment, be patient, and trade with care.