Exchange traded funds have been around long enough to experience some wild bumps, which have caused regulators to implement new rules to help smooth out the ride. The volatility experienced in February was also the first time these new rules were put to the test.
In a recent research note, Charles Schwab Investment Management investigated how ETFs fared during the February 2-8, 2018 volatility spike through an examination of trading volumes and flows, providing a detailed analysis on how ETFs mitigated market volatility.
“ETFs aided the market during a time of volatility by functioning as an effective risk transfer mechanism. The combination of a measurable increase in ETF trading volumes, disproportionately small corresponding net cash flows, and consistently tighter bid-ask spreads in large ETFs than in the underlying assets suggests that investors who used ETFs to reduce or add to market exposure benefitted from liquidity that was additive to the underlying asset markets,” D.J. Tierney, a Managing Director and Client Portfolio Strategist supporting Charles Schwab Investment Management, and Christopher Johnson, a Vice President and the Head of ETF Capital Markets supporting CSIM, said in a research note.
A variety of investors have adopted ETFs, using the investment tool as long-term asset allocation tools to help create low-cost, diversified portfolios or utilizing the funds as tactical vehicles to add or hedge various risk positions. For retail investors, financial advisors and institutions, the recent ETF flow and trading data during the bout of volatility in February indicates that these groups were well served during the market spike, according to Charles Schwab.
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Specifically, trading volumes soared. The dollar value traded in the U.S. equity market jumped by more than 110% above the 2017 daily average of $270 billion. On February 7, dollar value traded on U.S.-listed ETFs made up over 35% of the consolidated real-time data on trading volume and price for exchange-traded securities.
“The rise in ETF turnover on both an absolute and relative basis to broad equities amid the significant market volatility implies investors and traders chose ETFs over single stocks,” according to Charles Schwab.
What Flow Data Reveals About ETFs
Flow data also revealed that 12 of the top 25 ETFs had net outflows of $27 billion between February 2 through February 8, with most of the money yanked out of U.S. large-cap equity. Nevertheless, 12 ETFs attracted $2.3 billion in net inflows over the same period, with some international developed equities revealing inflows.
“In this scenario of large inflows and outflows, we saw that ETFs successfully expanded or contracted with investor demand, without material dislocation between market price and net asset value,” according to Charles Schwab.
Lastly, ETF bid-ask spreads widen marginally but almost always less than the bid-ask increase in the ETFs’ underlying assets.
“ETFs were still more cost efficient than trading the underlying asset class directly. ETFs allowed buyers and sellers to meet and reposition market exposures, thus serving as an effective risk transfer mechanism for the market overall,” according to Charles Schwab.
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