Exchange-traded funds are standing a little taller following February's equity market volatility.
Despite the as-designed collapse of several short volatility products, the largest and most liquid ETFs across asset classes sailed through significant market swings with barely a scratch, according to an analysis by FactSet Research Systems for Pensions & Investments.
"These ETFs kept on keeping on during the recent sell-off," said Elisabeth Kashner, the San Franciso-based director of ETF research for FactSet. "The primary job of an index-tracking fund is to do just that — track an index — and these funds delivered."
FactSet evaluated time-weighted average spreads, tracking difference, volume and change in shares outstanding for the 35 largest U.S.-listed exchange-traded products over the first 12 trading days in February. This time period captured a near round trip for the CBOE Volatility index, which measures implied volatility in S&P 500 stock index futures contracts, from 12 in late January to 50 on Feb. 6 and back to 19 by Feb. 16.
Trading spreads and index tracking error ranges on most products didn't even flinch. And not surprisingly, some of the most significant movement in spreads and changes in daily shares outstanding, a proxy for creation/redemption activity, were in interest-rate-sensitive equity ETFs, such as those tracking real estate and dividend stocks.
After all, it was the potential for rising wages and inflation, sparked by the Feb. 2 U.S. employment data, that had investors and traders reconsidering the pace and severity of interest rate moves by the Federal Open Market Committee.
Yet the market gyration was so extreme that Shelly Antoniewicz, senior director of industry and financial analysis for the Investment Company Institute, Washington, took time to run the numbers and deflect potential criticism of index-tracking funds.
"Market turmoil can be dramatic and unsettling, and it's natural for commentators and the press to look for causes and consequences," wrote Ms. Antoniewicz in a blog post on Feb. 14. "But it's wrong to assign responsibility for the market's movements to specific investing vehicles, such as index funds."
Index fund detractors have spent the years since the financial crisis arguing about the adverse effects indexation might have on asset markets, including allegations that ETFs and indexing increase stock correlations and distort valuations.
Partly for this reason, several fund providers and other market participants rushed to the defense of ETFs as well, armed with data. Such a visceral response bore the scars of disruptions past, which all caught the ETF market on its back foot. The 2010 "flash crash" exposed a weakness in ETF quoting. The 2013 taper tantrum demonstrated a need for education in how ETFs are a mechanism for price discovery in less-liquid debt markets. And the events of Aug. 24, 2015, when volatile overseas markets and a significant decline in U.S. equities futures delayed the opening of many stocks, showed exchange rules set up for equity trading caused ETFs to short-circuit due to trading halts.
While the industry was quick to point to market structure issues and wholeheartedly defend the soundness of ETFs themselves in each instance, there was still a need for product education.
The education this time around was more eye-opening, and directed back at the ETF providers.
Ravi Goutam, San Francisco-based head of pensions, endowments and foundations for iShares at BlackRock Inc., said he heard from one large institutional client that the performance of ETFs in February had them considering greater use of ETFs. Another client ran numbers to find that implementing a large emerging market equity position would be one-tenth the cost for an ETF vs. a futures contract. Lastly, another client remarked on the ability to trade a $400 million credit ETF position for just 2.5 basis points.
"I think we can put to bed the notion that ETF liquidity will dry up during market stress," said Luke Oliver, head of U.S. ETF capital markets for Deutsche Asset Management in New York. "In fact, this is exactly when market makers and liquidity providers see opportunity."
In fact, according to a BlackRock note, "secondary market trading was even more efficient than usual" in early February when ETF trading hit $1 trillion in aggregate from Feb. 5 to Feb. 9. "Creations and redemptions resulted in just 3.86% of U.S. equity market trading, down from an average of 4.32% in the 12 months ended in January."
"ETFs trade the most when the market is most stressed," said Bloomberg Intelligence ETF analyst Eric Balchunas, Princeton, N.J. "But the reason ETFs trade more in volatile times isn't because retail investors are all panicking, as some seem to think. It's mostly because many institutional investors use them for liquidity purposes, in a similar way they would use derivatives."
