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ETFs pass the liquidity test during recent market volatility

Vanguard | 05 March 2018


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Periods of market stress provide real-world tests for both investment products and investor beliefs.

Analysis observing investor behaviour, volumes and liquidity, conducted by Vanguard's Australian ETF Capital Markets division, shows that ETFs retained their liquidity and performed as expected during the recent market correction in February, while investors saw the opportunity to buy the dip.

Commenting on the analysis, Robin Bowerman, Head of Market Strategy & Communications at Vanguard said “The volatility through February which saw the Australian sharemarket down 4.93 per cent, followed by a bounce back of 4.73 per cent, has alerted investors to the reality that the benign market conditions of the past five years cannot continue indefinitely.”

“As markets return to more orderly trading patterns, our analysis captured how investors reacted and how ETFs operated during a time of higher market volatility.”

ETFs have experienced tremendous growth both globally and in Australia in recent years with many investors attracted to their low cost, diversification, ease of use and transparency.

The ETF market in Australia has now surpassed $35 billion in assets. On a global scale, assets invested in ETFs are now more than $US5 trillion.

Despite this success, questions have been raised about the potential for ETF trading to contribute to an increase in market volatility or lack of liquidity during periods of market stress. ETF growth has even prompted critics to question whether ETFs will somehow be a catalyst for the next severe sharemarket downturn.

Inextricably linked with the growth in ETFs is the growth in the use of indexing, and critics also question whether the increasing use of indexing will contribute to greater market volatility and even impact price discovery.

Historical data comparing market volatility and the Russell 3000 index shows that even as index funds' share of mutual fund assets has consistently grown, market standard deviation has risen and fallen in a way that shows no correlation with the growth of indexing, and dispersion among the stock market's securities has remained somewhat constant, except for the tech bubble and the global financial crisis.

Vanguard's analysis shows that during the week of 5-9 February, when global markets were feeling the impact of the US market correction, the Australian ETF market experienced a marked uptick in volumes traded.

In that week, Vanguard's Australian ETFs saw trading volumes on the secondary market double and primary market creations triple, compared to normal levels of activity.

Despite the added volatility in the market and the increase in trading activity, spreads in Vanguard's Australian ETFs only widened marginally and remained well within normal range. The average spread across Vanguard's Australian ETFs increased from 13.2 to 17.2 basis points, demonstrating the depth of liquidity inherent in the products, and the solid coverage by market makers.

A similar pattern emerged in other markets observed such as the UK and Hong Kong.

Earlier this month, Vanguard's Centre for Investor Research published analysis of US investor data over the same volatile period. Data from more than 8 million US households demonstrated the discipline of Vanguard investors, with analysis finding that 97 per cent of households did not redeem investments or alter their asset allocation during the period of 2-9 February.

While it is legitimate to question potential impacts when significant structural change in a product category is happening, based on the recent market gyrations there is little evidence to suggest that ETFs contribute to greater volatility during market events” Mr Bowerman said.

“One of the powerful attributes of ETFs is that they allow investors to express a view on markets or market sectors efficiently through the listed exchanges – generally at a much lower cost than other investment vehicles.

“Vanguard's analysis of the recent market data cannot find any evidence to support the claim that ETFs contribute to or worsen market volatility.

“The bottom line is that broad-based, well-diversified ETFs passed the recent liquidity test during a time of market stress. ETFs continue to offer investors the opportunity to trade both in and out of market exposures at narrow spreads and in large sizes - when market prices are either rising or falling.”

Vanguard has seen strong adoption of its ETFs in Australia with $2.9 billion flowing into Vanguard ETFs in 2017, bringing total Vanguard ETF funds under management in excess of $10 billion.