Don’t get distracted: ETFs emerge battle-tested again

Heavy volumes did not translate into massive outflows in last week’s volatile markets.

Smart-phones have changed our lives for the better in countless ways. They’ve also ushered in new forms of distraction.

As markets tumbled last week, investors flipping through their phones no doubt saw a flurry of sensational headlines about the influence that exchange-traded funds (ETFs) exerted on market prices.

Avoiding distraction is important to meet long-term investment goals and to understand the real story about ETFs.

Here are the facts: Sharp swings across global markets stoked heavy ETF trading volume but failed to produce an exodus from ETFs overall. Instead, we believe that ETFs helped investors transact smoothly and in large volume. Investors turned to ETFs during the commotion and, as one broker-dealer commentary noted, “ETFs are seen as a liquid hedging vehicle in times of stress” (source: Morgan Stanley ETF Desk Daily Trading Recap, Feb. 6, 2018).

Efficient transactions

Take a look at the numbers to see why. U.S.-listed ETFs recorded volumes of $240 billion and $260 billion on February 5 and 6, as stocks fell and then rebounded, among the busiest trading days on record in U.S. equities (source: NYSE). All told, U.S.-listed ETFs traded more than $1 trillion last week as the U.S. stock market suffered its steepest decline in more than two years. (Sources: NYSE; Wall Street Journal, “U.S. Stocks Rebound as Wild Week Ends,” by Corrie Driebusch and Riva Gold, Feb. 9, 2018).

ETFs accounted for nearly 40% of equity trading volumes on the heaviest days, relative to their five-year average of 26% (source: Morgan Stanley ETF Desk Daily Trading Recap, Feb. 6, 2018). And apart from a small number of exotic leveraged and inverse exchange-traded products (which have little in common with traditional ETFs and we believe should be classified differently), there were no service interruptions in traditional ETFs (source: Nasdaq Stock Market).

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Critics (many with entrenched interests) have long asserted that sharp market corrections could spur ETF and index fund investors to run for the door, exacerbating market risks. These “sky-is-falling” musings are nothing but conjecture, unsupported by real data and facts.

Don’t let them distract you. Despite their rapid growth, one recent tally found that ETFs represent roughly 4% of the global equity market by market value. (Source: BlackRock ViewPoint, “Index Investing Supports Vibrant Capital Markets,” October 2017).

The latest bout of market stress provides even more evidence.

Last week’s market volatility stoked elevated “secondary,” or on-exchange, trading volumes of more than $1 trillion. But net redemptions from all U.S.-listed ETFs last week were just at sliver of that total, at $29.9 billion (Source: Markit, BlackRock). Equity ETFs saw outflows of $28.1 billion; fixed-income ETFs saw outflows of $468 million.

In times of market stress, it’s typical to witness elevated secondary market ETF trading. This trading takes place peer to peer, between buyers and sellers.

A fraction of secondary volume trickles down to result in “primary” market activity, where ETF shares are created and redeemed based on supply and demand. Only in the primary market does ETF trading touch underlying stocks and bonds.

More to the point, a BlackRock analysis of last week’s trading showed that heavy secondary market trading was even more efficient than usual. Creations and redemptions resulted in just 3.86% of U.S. equity market trading over five sessions last week, down from an average of 4.32% in the 12 months ended in January.

Ultimately, it is investors changing their asset allocations that drive asset prices. We believe that the recent bout of market volatility underscores why ETFs are an option for investors seeking liquidity as well as why the naysayers are little more than a distraction.

Martin Small is the Head of U.S. iShares and a regular contributor to The Blog.

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