How do ETFs fare in a bear market?
Although exchange-traded funds have been around since 1993, there are still concerns about how easily investors can buy and sell in times of market stress. However, non-complex ETFs have shown their resilience over some of most volatile periods in recent history.
ETF market still growing strongly
Ernst & Young expects the exchange traded fund (ETF) industry to grow to $5.4 trillion by the end of 2018 and to continue to grow at annual rates of 10%-15% over the next three to five years. But even as the adoption of ETFs continues to flourish, some misunderstandings still exist.
One criticism is that investors may struggle to buy or sell their ETF at a fair price when prices fall quickly. In other words, people are sceptical about how liquid ETFs are during times of market distress.
What is liquidity and how is it measured?
Liquidity describes the ability to buy or sell a security quickly and cost effectively. A common measure of a security's liquidity is the size of its bid-ask spread. This is the price gap between the price buyers are willing to bid for the security and the price that sellers are asking for. The tighter the bid-ask spread, the more cost-effective it is to trade. In contrast, a wide bid-ask spread highlights illiquidity in the security which makes it more expensive to trade.
The largest determinant of the size of the ETF’s spread is what type of securities are held in the fund. Generally, equity ETFs have tighter spreads than fixed income ETFs since the average bond is less liquid than the average exchange-listed stock. Similarly, small-cap and emerging market equities are likely to be less liquid than developed equities.
The average published spread (source: Bloomberg) on the range of iShares ETFs that IG uses to construct its wealth product called IG Smart Portfolios is 0.16%, and as low as 0.03% on some of its largest positions such as iShares Core S&P 500 UCITS ETF (CSP1) and iShares Core FTSE 100 UCITS ETF (ISF).
How liquid are ETFs?
ETFs benefit from two separate sources of liquidity. The most common is through trading on the secondary market, where investors can continuously buy and sell amongst each other during market hours.
Investors also have the option of placing an order on the exchange or by requesting a quote from a market maker. On IG’s share dealing platform, the majority of clients trade via a quote since this generally results in an improved price compared with the best bid or ask price available on the order book.
The ability to buy and sell ETFs intra-day is a major benefit for investors compared with other fund types such as unit trusts and open-ended investment companies (OEICs) which are instead priced, and trade, just once a day.
Another source of ETF liquidity comes from the primary market, where trades are made by the fund manager in the ETF’s underlying portfolio. Shares in ETFs can be issued or withdrawn from the market according to investor supply and demand through a process called creation and redemption. This practice allows what are known as Authorised Participants (APs) to buy or sell new units of ETFs directly from and to the ETF manager, creating an additional source of liquidity.
However, the amount of creation and redemption activity is not as large as you may expect. Data from BlackRock, the largest asset and risk manager in the world, showed that over the week that the VIX spiked in February this year, net redemptions from all US-listed ETFs were just $30 billion, while trading volumes in the secondary market eclipsed $1 trillion.
Will I be able to sell my ETF in a crisis?
There are concerns that during times of market stress liquidity may dry up and investors may be hit by higher costs involved with buying and selling ETFs. However, research from BlackRock finds that this has not been the case for non-complex ETFs over one of most volatile periods in recent history.
The chart above plots the one-day move in the VIX index with the daily move in the S&P 500. While there have been plenty of other occasions where the US market has fallen by a greater magnitude, the surge in volatility on the 5 February 2018 was unparalleled.
However, during this event, which is now fondly remembered as 'volmageddon', BlackRock found its US-listed S&P 500 ETF traded on average within 0.01% of its net asset value (NAV).
We have also analysed the bid-ask spread for iShares FTSE 100 UCITS ETF and found the rise in volatility had little impact on the cost of trading this ETF too. ISF tracks the largest 100 UK-listed companies and is one of the largest with £5.6 billion in invested assets.
When volatility rises, the bid-ask spread on securities can widen and this increases the cost of investing. This in turn will negatively impact your long-run portfolio performance. The chart above shows the bid-ask spread for iShares FTSE 100 UCITS ETF (ISF) over October’s market sell-off, where the peak-trough fall in the FTSE 100 was 8.8%. Even with the rise in volatility, ISF’s spread during the week was incredibly consistent at around 0.03%. Only a couple of large US economic data releases led to short spikes in the spread and these quickly subsided.
In all, this shows that the cost of investing was little changed through this rocky period, with investors paying just £3 in spread on a £10,000 investment. This type of price behaviour proves how efficiently buyers and sellers were able to interact in the secondary market over one of the most volatile periods in recent history.
Investors should be wary of complex ETFs
The start of this article refers to the resilience of non-complex ETFs during the recent bouts of market distress. This accolade did not extend to the entire universe of exchange-traded products (ETPs) since there were a few complex products that did not fare as well when volatility rose sharply.
These were a subset of exchange-traded notes (ETNs) which sought to return the inverse daily performance of the S&P 500 VIX Short-Term Futures Index (VIX). On 5 February when the VIX index spiked 115%, the inverse ETNs tracking this index did exactly what they were supposed to do and fell around 90%, losing around $3 billion in value to the holders of these VIX related ETNs.
It is therefore important that investors are made aware that a small population of ETPs are far more complex and come with greater embedded risks than the universe of plain vanilla ETFs which do not exhibit traits such as leverage or targeting inverse performance.