ETFs: What Next for a Surging Market?

The market share of ETFs within the investment management industry continues to grow at a rapid pace, unbroken by the pandemic crisis. As of the end of 2020, ETFs represented about 12.2% of assets under management globally (US$7.6 trillion out of US$63 trillion, according to the European Fund and Asset Management Association).

The U.S. is leading this upward trend with a 17.5% market share, compared with 9.6% in Asia-Pacific and 5.4% in Europe. The rapid increase in the popularity of ETFs has sparked concerns among public authorities and academics over their potential to amplify market volatility in a crisis. In this regard, the March 2020 crisis can be seen as a live stress test for ETFs, and the broad consensus is that they acted more as a shock absorber than a shock amplifier.

Since most of the transactions took place in the secondary market, buying and selling flows were essentially matched intraday with real-time reaction to sharp market shifts from investors and arbitrageurs, hence preventing massive flows from materialising in the primary market at the end of the day.

The March 2020 crisis also highlighted the role of ETFs as a useful instrument facilitating price formation in increasingly illiquid market segments during that month’s peak volatility episode (equity and government debt ETFs aside). During this period, the corporate bond market practically froze while ETFs tracking fixed-income indices – both investment grade and high-yield – continued to be heavily traded.

A leading price indicator

Over the same period, some of these ETFs saw deep discounts versus their posted NAV, which raised questions over the arbitrage mechanism’s efficiency. As a matter of fact, ETF prices incorporated on-going market conditions faster than their posted NAV, the value of which were largely calculated based on stale reference prices due to the drop in liquidity of the underlying markets. ETFs were therefore a leading price indicator of their underlying index’s assets, while the NAV lagged. This serves as a reminder that an ETF values a basket of financial instruments as a whole and does not reflect the idiosyncratic risks attached to individual components.

The discrepancies between the ETF price and their posted NAV (as calculated end-of-day or intraday, “indicative NAV”) had a limited impact on investors and authorised participants (APs, generally market makers on these ETFs, who alone can trade ETFs on the primary market). Transactions on the primary market are generally in-kind, meaning that APs trade ETF shares against a representative basket of ETF holdings. As a consequence, APs are not affected by an ETF’s end-of-day valuation per se, but rather by the price at which the components of the representative basket would effectively trade in the secondary market.

Since the liquidity of certain underlying instruments dried up during the crisis, market makers needed to price in the uncertainty attached to this cost by widening their secondary market bid-ask quotations, thereby passing on the cost of liquidity to end investors.

Since investors can only trade ETFs in the secondary market, trading conditions (spread and liquidity) depend mainly on the quality of quotes from market makers, whether in response to Requests-For-Quotes (RFQ) for block trades or posted continuously on Lit markets. From an investor protection perspective, for the secondary market to function as efficiently as possible, a breadth of diversity of market participants is needed to increase volumes traded on Lit platforms. This would incentivise market makers to provide liquidity on a continuous basis, increase competition to capture market share by tightening spreads, and hence lower the cost of trading.

Emerging challenges

By improving trading conditions for investors, not only would a more efficient secondary market improve the ETF price-discovery process, it would also strengthen the quality of the market for underlying instruments. Hence, it seems logical to presume that an ETF’s most reliable market value lies somewhere between the bid-offer spread when sufficient firm (as opposed to indicative) orders define the spread. If it was not the case, other market participants could take advantage of such a situation by trading on either side of the spread until a new equilibrium is eventually found.

While ETFs have weathered the Covid-19 crisis quite successfully and, at least temporarily, may have reassured regulators and prudential authorities, new challenges may emerge in the near future. So far, ETFs are essentially used as a wrapper for passive, index-tracking funds. However, in 2019, the US Securities and Exchange Commission’s first approval of a solution that allows ETFs to be listed without fully disclosing their portfolios has sparked growing interest from investment managers in using ETFs as wrappers for funds that aim to generate alpha, as well as beta. It is not yet clear how popular these ETFs will become but, should their popularity take off, the shape of the investment management industry could undergo a radical transformation.

Furthermore, another consideration is that some ETFs are also a type of investment vehicle that offers leverage to investors, even though the ETF structure may limit their ability to do so (for example, in Europe, ETFs are usually UCITS whose leverage cannot exceed 210%).

In addition to amplified risks for investors, this type of ETF intrinsically amplifies shocks. Leveraged ETFs (and inverse ETFs) provide a multiple of the performance of their underlying index on a daily basis. Thus, their hedging needs to be rebalanced at the end of each day. This rebalancing is procyclical in nature and proportional to the variation of the underlying index; the more the market drops, the more the rebalancing will necessitate selling the underlying securities (and, conversely, buying in a rising market). With leveraged and inverse ETFs gaining greater popularity, the potential impact of their growth on financial stability should be watched carefully.

Another challenge that may soon emerge is the increasing investor interest in ETFs tracking some specific ESG themes, where the investable universe may be limited. An imbalance of inflows into such ETFs may impair the capacity of the underlying market to absorb such flows. This could result in inflated prices of underlying assets that would not necessarily reflect a rational anticipation of forward-looking performances of the companies in the underlying basket. In other words, the investor behaviour toward these assets could be different if they were to buy individual securities based on financial analysis and sound growth expectations.