By John M. Jascob, J.D., LL.M.
The ecosystem for exchange-traded funds (ETFs) remained strong and functioned well during the unprecedented market stress caused by the COVID-19 pandemic, according to a new paper issued by the Investment Company Institute (ICI). Contrary to the predictions of some policymakers, ETF shares traded smoothly and efficiently, with dealers continuing to make two-sided markets in ETF shares, the paper finds. ETFs also acted as a price discovery tool for investors, particularly in the fixed-income market, where market participants faced challenges in finding liquidity and establishing pricing for individual bonds.
"ETFs and their ecosystem emerged from this real-life ‘stress test’ with distinction," said ICI Senior Director of Industry and Financial Analysis Shelly Antoniewicz in a news release. "This evidence should help ease the concerns of policymakers and others about the role ETFs play in our financial system during a crisis."
The paper, "Experiences of US Exchange-Traded Funds During the COVID-19 Crisis," was issued under the auspices of ICI’s COVID-19 Market Impact Working Group. The working group, which includes senior industry executives, is examining the causes of the market turmoil in early 2020 and the experiences of regulated funds.
The paper notes that a common hypothetical scenario offered by some observers was that investors faced with a negative external event would rush to sell ETF shares in the secondary market, only to find few buyers, creating a vicious cycle of ETF redemptions and asset sales that would cause a downward spiral in asset prices. Evidence from the events of March 2020, however, showed that the ETF ecosystem of issuers, authorized participants, and liquidity providers performed well, which should help ease concerns that ETFs would put additional pressure on the financial system during a crisis, the paper states.
For example, the paper found that the ETF primary market remained robust in March 2020. ETFs did not experience mass net outflows. For the month, ETFs had total net inflows of $8 billion or 0.2 percent of their February assets. Moreover, demand for domestic equity ETFs was very strong in March, despite the severe contraction in the S&P 500 and spikes in volatility to levels unseen since the global financial crisis of 2007–2009. Net inflows to domestic equity ETFs were actually strongest during the weeks ended March 11 and March 18 when the S&P 500 was dropping fastest, falling more than 12 percent each week, the paper states.
Another theory suggested by some commentators was that authorized persons would step away from creating and redeeming ETF shares, putting further stress on financial markets. A survey of ICI members, however. showed that associated persons facilitated a significantly higher volume of ETF creations and redemptions for more ETFs during the March 2020 stress period than in March 2019. And, rather than pulling back, more associated persons, on average, participated in ETF primary market activity during the crisis in March 2020. Even with the modest net inflows to ETFS in March 2020, a flurry of ETF primary market activity occurred. More than 700 ETFs had at least one creation or redemption of shares in the March 2020 stress period, an increase of 38 percent over the activity of the prior year.