As exchange traded funds grow in popularity, some critics have grown concerned about the potential liquidity risks in times of financial distress that could cause investors to lose out when redeeming ETFs that track less liquid underlying assets and only provide an illusion of liquidity.
“The ‘illusion’ story is often trotted out in reference to bond ETFs. Far from posing risks in times of market stress, however, bond ETFs actually relieve pressure on their underlying securities and enhance liquidity,” writes Paul Schott Stevens, president and CEO of the Investment Company Institute, for InvestmentNews.
Stevens pointed out that ETFs trade on the secondary market and leave the underlying securities untouched. ETFs would provide an efficient and cost-effective way for anyone to gain exposure to a particular asset class through a simple brokerage account.
Historical data also supports the notion that ETFs boosted market liquidity in times of volatile conditions as more investors turned to the ETF investment vehicle to quickly execute trades on various assets.
For instance, in the summer of 2013 when the Federal Reserve hinted at an end to its quantitative easing program, the bond market took a nosedive but the secondary market liquidity in bond ETFs increased nearly $5 billion per day, compared to $3.8 billion in the four months prior to the announcement. Moreover, the ratio of bond ETF creations and redemptions activity to total bond ETF activity in the primary and secondary markets remained constant at 18% throughout the ordeal, which suggests that there were enough ETF buyers to pick up the slack from an uptick in selling activity on the secondary market.[related_stories]
More recently, in late 2015, high-yield bonds sold off after markets reassessed risks in the sector. Stevens pointed out that ICI analyzed how the junk bond ETFs performed during this upheaval and found they added liquidity to the market.