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.
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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.
“In the face of sharply falling prices, sellers of high-yield bond ETFs found willing buyers in the secondary market,” Stevens said. “Again, there was no flood of redemption requests. This secondary market trading of ETF shares relieved pressure on trading in the high-yield bond market by providing an alternative mechanism for investors to adjust their exposure to high-yield debt, enabling investors to efficiently transfer risk among themselves.”
Critics will also single out August 24, 2015 or the so-called mini flash crash as sticking point over ETF and liquidity. While some equity ETFs experienced heavy declines that diverged from their underlying net asset values, the anomaly was attributed to structural flaws in the exchange, notably those associated with the ETF arbitrage system, which have been addressed by the Securities and Exchange Commission.
SEE MORE: SEC Scrutinizes ETF Industry, Mulls New Rules
“Often ignored is that these ETFs did not experience significant redemptions, and their prices were back to equilibrium within an hour of the opening bell,” Stevens said.
More telling was the fact that bond ETFs, which many believed showed a false sense of liquidity, encountered no difficulties on August 24.
“ICI research shows that bond ETFs were resilient, and that there was no apparent spillover from equity to bond ETFs that would indicate a general problem with the ETF structure,” Stevens added.
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