Ever since the so-called mini flash crash, observers have been wary of any potential fallout in the exchange traded fund space during severe market volatility. However, as witnessed in the recent Brexit-induced selling, the ETF industry quickly adjusted to the changing prices.
According to the Investment Company Institute, after an initial divergence in ETFs’ share price and those of their underlying assets in response to the United Kingdom’s surprise vote to exit the European Union, U.S. stock and bond ETFs returned to more normal pricing to their net asset value, reports Daisey Maxey for the Wall Street Journal.[related_stories]
Specifically, ICI found that arbitrage activity – the mechanism by which market makers create and redeem ETF shares to take advantage of price changes between the ETFs and underlying assets – worked as intended in the hours after the vote. When a price disparity manifested, arbitragers were able to bring the price of ETFs back to or near the net asset value of underlying holdings.
“What it shows is that for U.S. ETFs on that day, the arbitrage mechanism was able to function very smoothly and efficiently,” Shelly Antoniewicz, the ICI’s senior economist, told the Wall Street Journal. “You had a little bit of initial selling pressure, but quickly, the arbitrage function got right to work and that gap closed up really rapidly.”
The smooth arbitrage process in ETFs this time around provided some assurances to the fund industry. In contrast, during the mini flash crash of August 24, 2015, when the Dow Jones Industrial Average plummeted over 1,000 points, a number of ETFs traded at steep discounts to their NAV after arbitragers were unable to receive up-to-date information on market prices and refrained executing normal ETF trades.
Antoniewicz also pointed out there were a few other key differences between the mini flash crash and the Brexit sell-off. For instance, there was more selling pressure in August 24 and the initial gap that opened between ETF share prices and the NAV was smaller.
The ICI, though, would still like more structural changes to make sure U.S. markets can properly react to stressful periods.
The Securities and Exchange Commission has taken steps to address the mini flash crash issues. For instance, in an attempt to obviate another mini flash crash scenario in the equities market and stock ETFs, the SEC approved plans to allow the New York Stock Exchange to speed up and smooth out early morning trades during more volatile conditions.