ETFs are one of the routes by which once alternative and elite-access-only strategies have become democratized or gone retail. As a result of this trend, we have synthetic ETFs, smart beta ETFs, leveraged ETFs, and inverse ETFs. A recent study study provides some reassurance about concerns that have motivated kickback against this trend.
Last month, analysts at Société Générale took the view that, tragic though it is, the coronavirus crisis may be regarded as a real-time experiment in the consequences of ETF investing. Further, they contended that ETFs have passed a liquidity test. This conclusion has held up in the weeks since, as trading volumes in ETFs have surged.
The SocGen study looked specifically at the iShares iBoxx $ High Yield Corporate Bond ETF, which saw record high trading volumes and outflows on Feb. 28.
If ETFs were destabilizing in the ways some theorists have long claimed, then this fact would have shown up on Feb. 28. Market makers would have been forced to facilitate liquidity through redemptions in the primary market and this would have drained liquidity out of the underlying securities.
Why it Matters
To understand why this matters, consider that a little less than a year ago three analysts affiliated with the European Systemic Risk Board co-wrote a paper titled “Can ETFs Contribute to Systemic Risk?” The authors of the ESRB paper are Marco Pagano, Antonio Sanchez Serrano, and Josef Zechner.
For purpose of the ESRB discussion “systemic risk” was defined as the risk of a disruption in the financial system that would produce “widespread instability in asset prices, extensive and material losses by investors and financial intermediaries, and possibly the collapse of important financial intermediaries.” For a risk to be “systemic,” in other words, it must affect a whole market and/or a large and significant group of institutions. This generally involves the creation of threats to the solvency of key financial intermediaries and investors.
There is concern that the very existence of ETFs allows non-idiosyncratic information to increase price co-movement. Empirically, this development “seems to go along with more left-skewed return distributions and larger downside risks, especially in stress situations when the VIX index is high or ETF redemptions are high.” That suggests in turn that large short-term directional bets in the ETF market could eventually result in market crashes.
The ESRB report looked at the holdings of ETF shares in the Euro area, where investment funds are the main investors. The direct exposure of banks is quite limited. Households have significant holdings though, especially those in Germany, Italy, and the Netherlands. Individual ETF holders are typically quite sophisticated, with sizable portfolios and high levels of education.
Arbitrage as a Problem
One of the concerns of the critics derives from this sophistication. Precisely because the relevant investors are sophisticated, they are likely to arb the ETFs against the underlying. In turn, because they arb, ETF order flow could transmit non-fundamental shocks to the prices of constituent securities.
The Pagano paper mentions contrary evidence (though one must read rather deeply into the report to get to it), by Box et al. (2019) that takes a markedly benign view of the consequences of ETFs.
Box looked at intraday arbitrage opportunities between 423 US equity ETFs and the portfolios of their constituent stocks from 2006 to 2015. He found that the mispricing of the ETF relative to the underlying was very generally preceded by a permanent price shock in the constituent portfolio and that this then was corrected not through arbitrage at all, but by quote adjustments. In short, he found none of the transmission of shocks to the underlying from the ETFs via arb that theorists worry about. Indeed, Box contends that ETFs that he studied improved the robustness of markets by letting market makers in the constituent securities offer greater liquidity.
Back to Société Générale
Now we return to the Société Générale study, which confirms the optimism of the Box paper and undermines the pessimism that is the main thrust of the ESRB paper.
The SocGen team found that ETF primary market flows on Feb. 28 only accounted for a small portion of the ETF volumes in the secondary markets. The market makers were not forced to redeem in the primary markets, so there was no liquidity drain.
On the contrary, the analysts said, their data “suggests the ETF has continued to rely more on its intrinsic liquidity than on the liquidity of the underlying bonds.” Buyers in the secondary market have stepped in.
Sébastien Lemaire, head of ETF research at SocGen, said that the study shows “the liquidity of this ETF has been remarkably resilient.