Franklin Templeton’s Head of EMEA ETF Capital Markets, Jason Xavier, explains the role of exchange-traded funds in enabling price discovery during these volatile times.
At the time I’m writing this, US markets have plunged, marking their worst one-day decline since 1987! Many European markets were also down more than 10% on the morning of 16 March after the US Federal Reserve cut interest rates to almost zero and launched a US$700 billion stimulus programme. Today’s close marked the first time a generation has seen daily equity market losses of this magnitude—declines that haven’t been seen since Black Wednesday in 1992 and the crash of 1987. And while painful and severe in the near term, just like volatile periods of past, opportunities will be created for the long term.
The comparison with 1987 is very relevant for exchange-traded funds (ETFs), as it was post this crisis that the US Securities and Exchange Commission (SEC) consulted the market to develop a product that would facilitate the addition of liquidity, allowing large blocks of equity to be bought/sold in a single trade. Not too long thereafter, the ETF was born!
Since the first ETF was launched 30 years ago on the Toronto Stock Exchange and then a few years later in the United States, it’s clear ETFs have long passed their initiation! Even up until recently, concerns that ETFs will cause the next downturn or that ETFs create and exacerbate volatility have been topics for discussion in some corners.
As a reminder, volatility is a function of investor flows, and is driven by human behaviour. Even as market volatility skyrocketed, last week was proof that ETFs have not only enabled the democratisation of asset classes, but are also now being actively used as a price discovery mechanism, particularly within fixed income.
Appreciating market uncertainty in relation to the trading of ETFs is key to appreciating the price discovery mechanism ETFs offer—and many investors utilize—during these volatile times.
The last few days have seen underlying securities trade at extreme levels and at times trade limit down during the trading day. During these limit-down periods, trading is halted and price discovery in the underlying securities is limited. At these moments, market uncertainty is at its peak and the lack of clarity around prices have caused ETF spreads to widen.
However, the ability for ETFs to trade in the secondary market as well as for ETF market makers to setup proxy hedging and correlated pricing models has allowed price discovery and liquidity to be upheld, even during these stressful and uncertain periods.
Three decades since the inception of the first ETF, the product is now more relevant than ever. As more and more investors embrace its abilities and potential benefits, a new generation of them is already taking full advantage of intentions laid out from yesteryear’s volatile periods.
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What are the risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
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