ETF Stream: During the worst of the coronavirus sell off in March we saw Vanguard’s ETF investors continuing buying as the share market tanked 30%. Why was that? Was it retail investors buying the dip?
Evan Reedman: In March about $580 million entered our ETFs. The Vanguard Australian Shares Index ETF (VAS) was the most popular.
In terms of who was buying, a lot of the trades were coming from CommSec, which is mostly used by retail investors. And yes, they were buying the dip.
It wasn’t just retail investors though: advisers were also buying. In some instances, they were buying the dip too, but for their clients. In other cases, advisers were executing on investment plans where their clients have goals that might be 20-40 years out.
In March and April some Vanguard bond ETFs blew out on discounts. What happened?
Much of the discounts stemmed from how the bond market works – especially the corporate bond market.
Australian companies’ bonds are traded in a very different way to their shares. When you buy and sell a company’s shares on the ASX, you have a list of buyers and sellers and a list of prices they’re willing to transact at.
The Australian corporate bond market by contrast is mostly run by the big banks and brokers who trade bonds between themselves. The market is over the counter, meaning it cannot be accessed by retail investors. Banks and brokers then negotiate prices. There’s no central reporting of trades and prices like there is for shares. Some examples of platforms used for bond trading include Tradeweb and Bloomberg TSOX.
So ETFs and bonds trade in different places and in different ways. Where this gets challenging is that ETFs trade more frequently and more transparently than the bonds they hold. The result is that ETFs can be trading even when the bonds they hold aren’t, and discounts emerge because ETFs are absorbing a lot of the selling pressure.
I’d emphasise, however, that it is not the ETF that causes that. It’s a function of the underlying bond market.
How do you price bonds and bond ETFs, if bonds are not trading?
Bond pricing for ETFs is done by two different groups. First there are traders, like market makers and banks.
Second there are service providers like Interactive Data, the calculation agent, and JP Morgan, the custodian. They try and price the bonds inside an ETF and figure out how much the fund is worth, or the net asset value (NAV).
Where things get challenging again is that these companies can have different sources of information they’re working off.
Market makers, for their part, will mostly use trading tools in order to price the bonds an ETF holds. At its easiest, when the bonds are heavily traded, they’ll just go off the traded or quoted prices. For bonds that aren’t trading, they’ll look at the prices of similar derivatives or go off comparable bonds. But their sources of information can be pretty broad.
For the NAV, the calculation agent will usually use some kind of model based on similar things to the market maker.
ASIC has raised concerns that ETF market making is dominated by just three investment banks: Susquehanna, Deutsche and Jane Street. Is this something that concerns Vanguard?
Concentration in market makers is an issue for the industry as a whole – absolutely. The more market markers covering ETFs the more price competition and this is good for investors.
For us, all of our ETFs are covered by two or more market makers.
Some ETF spreads widened significantly in April. Personally, I was quite surprised, especially given that most market making is assisted by ETF providers, who give them cash-based creation and redemption.
There’s a number of things to say here.
We offer both “in-kind” and cash creation and redemption on most of our ETFs. For some of our ETFs – especially domestic equity ETFs like VAS – we encourage “in-kind”, especially as there can be lower fees.
When volatility rises, market makers can prefer cash redemption, meaning that Vanguard’s traders are doing the buying and selling of securities.
Now, this effects spreads because cash creations come with higher fees. These fees can move around, but usually fees increase when there is more volatility in the underlying securities – as the underlying cost more to trade. Market makers then pass on these higher fees as wider spreads.
Big superfunds have avoided ETFs. Do you have any idea why?
Superannuation funds are very comfortable using futures or forwards or some other derivative to get index exposure.
Big institutions also usually have specific requirements for their investments that can be quite bespoke. These can vary from something simple like an ESG screen that excludes tobacco companies, to something very complicated like requiring specific hedging due to their property portfolios. So due to these bespoke needs, the big superannuation funds haven’t wanted to use ETFs.
But most importantly, big superannuation funds have other options available to them – especially separately managed accounts (SMAs). Many institutions use SMAs. These typically come with minimums starting at $50-100 million or so and have fees in the single digit basis points.
How does Vanguard decide what ETFs to launch? Any plans for new ETFs?
There are two main things we think about: investment and clients. The investment aspect we think about is the long term and enduring reason for providing economic returns.
From the client perspective, we only launch products if we think there’s a clear need for a new ETF in the advisor and retail market.
In terms of new launches, we’re just about to roll out a new ethically conscious Australian shares ETF. It is from a different index provider, but it is something like an ESG-screened version of VAS that excludes fossil fuels, alcohol, controversial weapons and some other exposures.
We’re launching this because ESG has become a lot more mainstream especially since last summer’s bushfires.
Vanguard is a not-for-profit, right? I feel like you guys underplay that.
Jack Bogle, our founder, structured Vanguard as a client-owned mutual fund company, with no outside owners.
Vanguard’s ownership structure can’t be replicated outside the US. But it drives the culture and policies of Vanguard worldwide.
In Australia we’re structured as a company that’s wholly-owned by the US parent. Australians benefit from our scale and the structure of our US parent. In the past 10 years in Australia we have brought in 25 reductions to fund management fees.
What’s your favourite ETF?
If I were forced to choose I’d say VAS. My early days of investing were around the privatisation of assets, like the Commonwealth Bank and Telstra. So for me that was the introduction to investing. It’s been a great vehicle to educate the investing public about diversified portfolios. And then, as an introduction to the ETF market. It opens the door to have those two conversations with investors.