Given the rapid growth in both ETF assets and sales in recent years, questions have been raised about the broader associated risks and market stability related to this investment type.
The Covid-19 financial crisis posed an unexpected test of these concerns. Based on a thorough examination of the data, ETFs proved their resilience during a challenging time.
Leading up to Covid-19, some academics and policy-makers hypothesized that investors, when faced with an external shock, would rush to sell their ETF shares in the secondary market and find few buyers. Liquidity providers (market makers and designated brokers) would step back from their role of making markets, and ETF shares would be redeemed with the associated sale of underlying securities. At worst, a downward spiral would ensue, with those asset sales resulting in declining prices in underlying markets, and with declining prices and asset sales causing further ETF redemptions.
In a previous Inside Track column, I stated that mutual fund investors did not, in fact, run for the exits in market crashes. The same, it appears, holds true for ETF investors.
During the Covid-19 market selloff, virtually all assets experienced unprecedented levels of drawdown and volatility. Between Feb. 20 and March 23, the S&P/TSX composite index fell by 37%. As fixed-income instruments were sold to raise cash, bond prices fell, and significant parts of the fixed-income landscape (certain corporate bonds and government treasuries) even went “no bid.”
Despite these pressures, there was no fire sale.
IFIC examined its own asset and sales data and found that investors, in aggregate, withdrew from bond ETFs during March, April and May 2020. However, net redemptions were modest, and inflows quickly resumed in June. The monthly net outflow from bond ETFs as percentages of starting assets was 1.8% ($1.2 billion) in March, 0.9% ($629 million) in April and 0.1% ($56 million) in May. Also, investors did not halt their purchases during the most stressed periods. In fact, when gross redemptions were at their highest in March 2020, gross sales were also at their highest.
With respect to liquidity providers, rather than pulling back, they stepped up. In an analysis conducted by ETFGI on behalf of IFIC, the global research firm found that the number of market participants reporting ETF trades on the TSX increased from 49 pre-pandemic to 60 during the Covid-19 period. The analysis was based on a sample of 133 TSX-listed ETFs (66 equity and 67 fixed income) that track Canadian benchmarks.
In related research examining corporate bonds, National Bank of Canada Financial Markets (NBCFM) found that as trading volumes and creation and redemption activity more than doubled at the height of the crisis relative to historic levels, market makers and designated brokers continued to provide liquidity. NBCFM observed that this was true even as the level of investor activity on the secondary market — so-called natural buying and selling — declined significantly.
The experience in Canada is clear. Designated brokers and market makers facilitated ETF creations and redemptions throughout the selloff of bond ETFs, and there is no evidence they stepped away or failed to meet their obligations to provide quotes during what turned out to be a very stressful period.
Throughout the crisis, investors did not dramatically increase their redemptions or halt their purchases of bond ETFs. There is also no evidence that ETFs affected the underlying bond markets in a negative way. This is in part due to the balance of buying and selling throughout the market stress, but it is also due to the relatively small amount of ETF trading in the broader bond market. ETF primary market trading volume is about 2% of total Canadian bond trading volume. In fact, when underlying bond liquidity was going down, ETFs offered access to an otherwise frozen market.
While ETFs proved their resilience in Canada, research conducted in the U.S., U.K. and by the International Organization of Securities Commissions (IOSCO) found a similar experience in other jurisdictions. The IOSCO research, which surveyed several financial markets, concluded that the ETF structure was “relatively resilient” throughout the market stress and that no imminent risks were identified from a regulatory or financial stability perspective.
ETFs provided an “additional layer” of liquidity, the research found, and fixed-income ETFs played a role in providing additional pricing information for the underlying bond markets during the period.
Paul Bourque is president and CEO of the Investment Funds Institute of Canada.