Myth 4: ETFs will break when markets go south – If the market is in turmoil; how confident can an investor be that: market makers will continue to make orderly markets (tight bid-offer, significant depth), ETF authorized participants (APs) will continue operating, the creation and redemption process for ETFs will operate as normal, and the premium and discount of price to intraday NAV will not deviate too far?
The Micro Scope
Before getting into the specifics of the ETF ecosystem, it’s important to pull back the lens on how large the ETF market is relative to the broad market, both in terms of total AUM and trading volumes. Take, for example, the high yield bond market. The high yield cash bond market reported about $11bn USD in trading volume per day in 2018 as compared to $2.5bn in ETF secondary trading and $400mm in ETF primary trading within high yield. On average, ETF primary activity represents just around 3.5% of the trading volume in the high yield cash market.
(Source: Bloomberg, DWS Calculations as of 9/26/19).
The reliability of market makers and APs to continue to carry out ETF trading activity is essential to sustaining investor confidence in the ETF market, especially during periodic market stress. In practice, APs can create or redeem new ETF shares with the issuer at a fair value in the primary market. This allows APs to act as arbitrageurs when ETF prices deviate from their fair market value. For this arbitrage mechanism to make economic sense, the premium or discount present in the ETF secondary market has to exceed the creation or redemption costs (i.e. custody costs, financial transaction taxes of underlying securities, commissions, etc.). One concern that arises among ETF investors is, since APs are not required to step into the market, how can we have confidence that they will serve their important role at all times? The answer is the role that lead market makers play in the ETF ecosystem. U.S.- listed ETFs have one lead market maker (European ETFs have two) with clearly defined quoting obligations to make a continuous 2 sided market during regular trading hours1.
For each ETF, there is a large number of independent profit-seeking APs whose profit incentives directly align with goals of ETF investors, which are to access the underlying markets of ETFs at a fair price and with the assurance of liquidity. For example, Xtrackers currently maintains relationships with 28 different APs. In the past, when APs or market makers have withdrawn from the ETF market, there was very little impact on the resilience of the ETF ecosystem and its ability to provide liquidity to investors. In addition to APs, which are only the subset of brokers that create and redeem shares directly with ETF issuers, DWS Xtrackers as an example, also maintains a broad relationship with over 100 brokers who serve as an additional liquidity valve to ETF investors.
The reliability of liquidity providers to effectively keep prices in line with NAVs relies on their ability to access financial instruments that allow for the seamless arbitrage of ETFs to their underlying baskets. In periods of financial stress, concerns will sometimes arise as to the capacity or willingness of APs to operate in this manner on a continuous basis. When underlying liquidity is insufficient to allow for immediate arbitrage of NAV/price disparities, liquidity providers are still able to leverage a much broader toolkit of investment vehicles in order to generate profits. This includes the utilization of quantitative models to replicate market risks using other instruments (e.g. hedging high yield risk with S&P futures) as well as having the flexibility to take on, or warehouse, market risk.
Ultimately, ETF prices are a reflection of current market liquidity conditions through the behaviors of APs as well as other brokers. And given improvements in underlying market liquidity across equities and fixed income through the advent of numerous electronic trading platforms, the ease by which ETF markets operate is, if anything, improving significantly, in our view.
1) Quotations requirements include:
_ LMMs must maintain continuous, two-sided quotes for each security in which the firm is registered as lead
_ LMMs must meet minimum performance requirements which include a Best Bid Best Offer requirement, minimum displayed size, minimum quoted spread and participation requirements for opening and closing auctions.
In return for meeting these obligations, LMMs will receive a superior fee structure for their LMM allocations.