When markets experience extreme volatility spikes, investors tend to think tactical. They want liquidity, and very often they find it in ETFs. On June 13, U.S. fixed income ETF trading hit a record daily high of $58 billion, surpassing the previous mark of $53 billion when markets spiraled as the reality of the Covid pandemic became clear.
An urge to reach for ETFs during excessive turmoil is rooted in equity markets, where ETFs originated. It’s not uncommon on a highly volatile trading day for ETFs to represent well over a third of the entire equity tape.
The reflex to think of ETFs in only a tactical context, however, doesn’t maximize the role ETFs can play in a portfolio.
“When significant volatility surges occur, investors instinctively think: ‘What’s the most liquid asset I can trade?’” says Del Stafford, Managing Director, Head of iShares Americas Portfolio Consulting, at BlackRock.
“That craving for liquidity in their existing portfolio extends when they look to pivot by rebalancing, too,” Stafford continues. “When markets become much more volatile what they view as existing liquidity in their portfolio can begin to dry up.”
But what if they used ETFs to be better prepared for unanticipated volatility spikes before they happened?
Creating a rebalancing sleeve
Stafford advocates for a persistent presence in portfolios of what he refers to as a rebalancing sleeve or a liquidity sleeve. Such a sleeve, consisting of a mix of ETFs most suited for the investor, can act as a buffer.
“A rebalancing sleeve allows you to invest at a benchmark level with somewhere between 5% t0 10% in ETFs,” says Stafford. “When the market experiences sudden volatility jolts, you can rebalance in the most liquid and cost-effective investment while protecting your alpha strategies. Regardless of whether you’re moving from fixed income to equities or equities to fixed income, you want to do that within your ETF portfolio because it would be the exact wrong time to touch individual securities or alpha managers.”
As much coverage as ETF usage receives in the media, Stafford says there is plentiful room for them to grow as institutional investors recognize their efficacy beyond tactical needs – especially in fixed income.
“Many investors still think of ETFs solely from an equity perspective,” says Stafford. “I’m not saying fixed income ETFs are brand new, but many investors have been using them for the first time during recent market stresses.”
For such investors – and those already using them – it is time reimagine what they could be doing with them, says Stafford. And the timing is right, too, as many institutional investors undertake rebalancing activity triggered at the mid-year point. Stafford expects more than usual rebalancing happening, however.
“We expect additional rebalancing because tracking error is influenced by volatility,” says Stafford. “Even if it were possible to hold a portfolio’s return constant, higher volatility would still increase tracking error.”
Investors yet to adopt a rebalancing sleeve, says Stafford, may wish to challenge their mindset of using ETFs for tactical exposure and instead consider fundamentally changing the way they manage liquidity in their portfolio.
“It’s a different mindset, and requires little bit more portfolio re-engineering,” says Stafford. “If you’re an asset manager and handling your own strategy, it may be an easier transition to make. For an institution with a board and stakeholders, it’s a different decision-making process but it’s a conversation worth having in light of more frequent volatility spikes.”
It’s a trend that may well be gathering momentum. Stafford notes that during recent periods of heightened volatility iShares flows have stayed within the ETF universe.
“For example, instead of selling out of high yield and maybe moving into a cash product that’s a non-ETF, we’re seeing more investors express that view with an ETF – in the scenario I’m describing, perhaps a short TIPS ETF of floating rate ETF,” says Stafford.
“The assets are remaining inside the ETF ecosystem,” he continues. “And that’s good for the liquidity and continuing growth of the ecosystem.”
