ETFs can provide stability in times of market stress, says IA study

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The Investment Association has published a new paper looking at how ETFs performed during the market volatility earlier this year.

‘ETF Performance During Coronavirus: An Expanded Analysis’ finds that the crisis demonstrated that ETFs can be a source of stability and price discovery during periods of significant market stress. 

“In the early weeks of the crisis, ETFs saw significant outflows and traded at unusually large discounts to NAV. Concerns were raised that this represented a failure of the arbitrage mechanism that normally keeps ETF prices stable, while representing a downward drag on bond markets, particularly those in the investment grade corporate bond market space. 

“However as this paper has demonstrated, far from representing a failure of the arbitrage mechanism, the discounts seen in the early weeks of the crisis (and, indeed, the premiums that were witnessed later on), represented the arbitrage mechanism working exactly as intended, as market makers and APs were able to bid ETFs intraday based on the ‘real’ price at which the underlying bonds could be bought and sold, rather than the out-of-date, ‘stale’ prices attached to the underlying securities.”

The IA writes that this is because in a time of market stress investors turned to ETFs for transparency and liquidity. 

“ETFs saw record primary and secondary trading volumes during the height of the crisis. When trading in the underlying markets was impaired, with a resultant impact on pricing services’ abilities to provide intraday pricing, ETFs offered a source of both additional liquidity and price discovery, with traders being able to use ETFs to estimate the prices of the underlying bonds. Far from dragging down the price of the underlying securities, ETFs were in fact simply providing a forecast of where the price of those underlying securities would ultimately fall to, as would indeed occur as the crisis wore on and discounting was reduced to normal levels.”

The Association finds that other factors created far more of an impact on bond prices and liquidity, including large outflows and mass redemptions from bond funds during the height of the crisis. 

“AP arrangements also proved resilient during the crisis, with [no/little] reduction in the number of active APs operating in the ETF during March and April. This, along with the important roles played by market makers and broker-dealers, as well as the option for investors to create or redeem directly with an ETF provider in the remote event AP arrangements fall away entirely, should help assuage regulator and policy maker concerns as to the strength of AP arrangements and investor protections within the industry.”

The IA concludes that ETFs remain a small part of the overall market, and their effect on the market as a whole should not be over-exaggerated. 

“Nonetheless, it is clear that ETFs provided a useful tool over the course of the crisis, both to investors seeking liquidity and a source of price discovery, and to central banks as they looked to intervene to stabilise markets.”

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