Beyond Bulls & Bears

The Liquidity Unicorn: Are any ETFs Truly Bulletproof During Market Stress?

In the ongoing discussion about liquidity and exchange-traded funds (ETFs), David Mann, Head of Global ETFs Capital Markets, examines a recent report outlining how ETFs have navigated the pandemic. He says it provides some validation that lower-volume funds are not all that different than higher-volume ones in navigating such crisis periods.

As the year draws to a close, I have slowly been working through some of the various research reports and white papers stacked on my office desk. One of those was the International Organization of Securities Commissions (IOSCO) report from a few months ago, which analyzed how ETFs handled the COVID-19-induced market stress of March 2020. You can find the link to that report here.

As my loyal readers hopefully know by now, this is a topic we have discussed at length over the past year and a half. Just to pick a few of the greatest hits:

There are not any major surprises in the report. Although looking back, I still cannot believe some of the premium/discounts and bid/ask spreads ETFs experienced in March of 2020. I should note that typically these reports are used to defend the ETF structure given that critics tend to speculate how unexpected market events might strain the ETF wrapper. This sentence is taken from the report’s summary:

“Overall, available evidence has not indicated any significant risks or fragilities in the ETF structure, although a subset of ETFs temporarily experienced unusual trading behaviors.”

I want to spend a little time on the second part of that sentence. One of the other recurring topics of this blog is that a fund’s relatively lower average trading volume or smaller size should not (and does not) limit an investor’s ability to buy and sell that fund. We discussed this topic again earlier this year, here.

We have example after example of investors able to buy multiples of the average daily volume with little to no market impact. Unfortunately, often, the higher volume funds with higher assets under management (AUMs) are chosen because of their perceived “liquidity” benefit.

Well, as this report shows, even high-volume funds were not immune to the market stress of last March. We have repeatedly tried to show that lower volume funds are more liquid than you think. Moreover, it is not fair to use a liquidity standard that does not even exist for funds with very high volumes—even if they are not bulletproof!! In times of extreme market stress, all funds—irrespective of their size or volume—could experience unusual trading behavior.

Our point from the start was that lower-volume funds can trade as efficiently as high-volume funds. We normally provide examples to the positive—entering or exiting a position during normal market conditions. The same also applies to trading during extremely stressed markets when premium/discounts are higher and spreads are wider.

Just make sure you do not expect high-volume funds be perfectly liquid in any market, which clearly wasn’t the case last March.

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. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. 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. 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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