There was no ETF death spiral. ETF liquidity didn’t evaporate. The ETF tail didn’t wag the market dog. Despite ETFs successfully passing numerous tests including the Dotcom crash, Global Financial Crisis, and more recently, a 20% drawdown in the fourth quarter of 2018, ETF fear mongering has remained remarkably difficult to kill.
“ETFs haven’t been battle-tested.”
“ETFs will exacerbate market disruptions.”
“What happens when ETF investors all rush for the exit at the same time?”
The Coronavirus may have finally accomplished what legions of ETF educators have been unable to do for years: kill several ETF myths. The virus itself is posing real risks to humans, the economy, and the financial markets. ETFs are not.
After hitting a record high on February 19th, the S&P 500 dropped nearly 13% over the next 7 seven trading sessions. It was the fastest stock market correction in history. As for ETFs? Let’s check some stats via Bloomberg’s Eric Balchunas:
-ETFs saw a record $1.4 trillion in trading volume last week.
-The SPDR S&P 500 ETF (SPY) became the first security to trade over $100 billion in a single day ($113 billion on Friday). For context, Apple stock averages approximately $6 billion in daily volume.
–ETFs accounted for 43% of all equity trading volume on Friday (normally about 25%).
-ETFs typically trade around $90 billion in shares/day. On Friday, they traded $414 billion and averaged $225 billion/day for the entire week.
Source: @mbarna6 via @EricBalchunas
Now, I can already hear the naysayers screaming, “Wait a minute! ETFs DID exacerbate the stock market decline. You just said it was the fastest correction in history!”. Let’s look at the facts.
Source: State Street SPDR ETFs/Matt Bartolini
The Russell 3000 index tracks the largest 3,000 U.S. companies and represents about 98% of the investable U.S. stock market. The above chart shows the total dollar trading volume in Russell 3000 stocks, along with gross primary activity (creations and redemptions) in US stock ETFs. Without getting too technical (which you can do here), the vast majority of ETF trading is investors swapping their shares with each other in the secondary market (buying or selling ETFs through Robinhood, Charles Schwab, etc). Primary activity entails ETF authorized participants (APs) actually buying or selling the underlying securities held in an ETF. So, what happened over the past seven trading days? Primary ETF activity averaged 3.3% of total Russell 3000 stock volume. That’s a blip and hardly evidence of the tail wagging the dog.
Ok, so stock ETFs functioned well, but surely bond ETFs struggled last week – right? Nope. ETF fear mongers love to point to high yield bond ETFs, proclaiming this is where a death spiral will occur during a market disruption. Back to the tale of the tape:
-The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) nearly doubled its all-time weekly trading volume record with $31 billion. That also obliterates the all-time bond ETF trading record.
-The two largest junk bond ETFs – HYG and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) – experienced their largest outflows ever. According to ETF.com, HYG lost nearly 28% of its total assets and JNK 15%.
In other words, there was plenty of primary market activity in both of these ETFs. So, what happened? Not much, really. Both ETFs traded within a normal arbitrage band (the difference between an ETF’s intraday price and its net asset value – think premium or discount). There was no death spiral. It’s worth mentioning that ETF prices are only as good as the prices of the securities they hold. If those underlying securities aren’t pricing properly, neither will the ETF or any other investment relying on those individual security prices. If the ETF is pricing at a discount, it’s likely the ETF is more representative of the actual bond prices.
Junk bond ETFs only represent approximately 4% of the entire junk bond market. It shouldn’t come as a surprise that their impact was relatively muted last week. Institutions, active mutual funds and individual investors hold significantly larger shares of the high yield market. Investors worried about junk bond ETFs should always ask the question, “What happens if high yield mutual funds or individual high yield investors have to sell?”. Why would that be any different than ETFs? A case could actually be made that mutual funds are riskier because they own a larger portion of the high yield market and tend to traffic in less liquid bonds (which can also help juice returns).
I could go on, but the bottom line is that compared to the record $1.4 trillion in ETF trading volume last week, there was only $24 billion in net ETF outflows. Simply put, that means ETFs were relied upon for liquidity during this period of market stress. WHICH MAKES PERFECT SENSE! Why? ETFs were actually created to PROVIDE a liquidity buffer! In other words, rather than exacerbate market downturns, ETFs were conceived to help INCREASE overall market liquidity.
For those who haven’t heard the story, ETFs were born out of the 1987 stock market crash, where stocks declined 22% in a single trading session. Following the crash, the Securities and Exchange Commission (SEC) produced a detailed report attempting to identify causes and develop potential solutions. The SEC believed a lack of liquidity in the markets was a major contributor to what was infamously dubbed “Black Monday”. Liquidity refers to the ability to easily buy or sell something without causing a significant change in prices. On Black Monday, a combination of factors triggered computer trading programs and portfolio insurance holders to begin selling stock market futures. The details here aren’t as important as understanding that the selling in stock market futures transferred over to individual stocks. Selling beget more selling, causing a downward spiral. Market liquidity evaporated. Everyone wanted to sell and nobody wanted to buy. With no other liquidity buffer or release valve in the market, individual stocks plunged. One of the ideas the SEC floated as a potential solution to help minimize future crashes was some type of a security that represented a basket of stocks, but could be traded just like an individual stock. The idea was that such a security could change hands without impacting the underlying stocks, providing additional liquidity to the markets.
“The SEC suggested that “an alternative approach be examined” and posited that if well-capitalized specialists and supplementary market makers could have turned to a single “product” for trading baskets of stocks, the market damage – and volatility – may have been significantly smaller. Indeed, such a product might even have prevented the crash by providing a liquidity buffer between the futures market and individual stocks.”
The rest, as they say, is history. The first U.S.-listed ETF, SPY, launched in 1993 and ETFs have never looked back. Unfortunately, as ETFs have grown in popularity, so too has ETF fear mongering. If there’s a silver lining in the Coronavirus-induced market action over the past two weeks, it’s that it might be killing off several ETF myths. But like viruses, ETF myths mutate. And they don’t go away easily.