ETFs, Volatility and a 30-Year Initiation!

Many people put a lot of thought into the purchase of an asset—whether it’s a car, an investment vehicle or even a more mundane item—but might not think as much about what happens when they don’t want it anymore. David Mann, our Head of Capital Markets, Global Exchange-Traded Funds, draws some parallels between buying and selling an ETF and one of those mundane items: a mattress.

We are living in truly unprecedented times.

At the time I’m writing this, US markets have plunged, marking their worst one-day decline since 1987! Many European markets were also down more than 10% on the morning of 16 March after the US Federal Reserve cut interest rates to almost zero and launched a US$700 billion stimulus programme. Today’s close marked the first time a generation has seen daily equity market losses of this magnitude—declines that haven’t been seen since Black Wednesday in 1992 and the crash of 1987. And while painful and severe in the near term, just like volatile periods of past, opportunities will be created for the long term.

The comparison with 1987 is very relevant for exchange-traded funds (ETFs), as it was post this crisis that the US Securities and Exchange Commission (SEC) consulted the market to develop a product that would facilitate the addition of liquidity, allowing large blocks of equity to be bought/sold in a single trade. Not too long thereafter, the ETF was born!

Since the first ETF was launched 30 years ago on the Toronto Stock Exchange and then a few years later in the United States, it’s clear ETFs have long passed their initiation! Even up until recently, concerns that ETFs will cause the next downturn or that ETFs create and exacerbate volatility have been topics for discussion in some corners.

As a reminder, volatility is a function of investor flows, and is driven by human behaviour. Even as market volatility skyrocketed, last week was proof that ETFs have not only enabled the democratisation of asset classes, but are also now being actively used as a price discovery mechanism, particularly within fixed income.

Appreciating market uncertainty in relation to the trading of ETFs is key to appreciating the price discovery mechanism ETFs offer—and many investors utilize—during these volatile times.

The last few days have seen underlying securities trade at extreme levels and at times trade limit down during the trading day. During these limit-down periods, trading is halted and price discovery in the underlying securities is limited. At these moments, market uncertainty is at its peak and the lack of clarity around prices have caused ETF spreads to widen.

However, the ability for ETFs to trade in the secondary market as well as for ETF market makers to setup proxy hedging and correlated pricing models has allowed price discovery and liquidity to be upheld, even during these stressful and uncertain periods.

Three decades since the inception of the first ETF, the product is now more relevant than ever. As more and more investors embrace its abilities and potential benefits, a new generation of them is already taking full advantage of intentions laid out from yesteryear’s volatile periods.