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Are passives passing the Covid stress test?

4 Aug 2020

With the dust settling on the financial market stampede of the first quarter, how have passive funds fared amid extreme volatility?

Critics of ETFs have warned that the industry, which holds more than $9trn (£6.9trn) of assets, has created an illusion of liquidity because the fund vehicles are more easily tradable than their underlying assets. This in turn could accelerate volatility in the event of a crisis.

This argument has been put to the test in the first round of the Covid crash and so far, ETFs appear to have performed well. In line with the overall market, ETFs booked sharp out-flows in March, with 80% of funds trading at a record discount level.

But passives responded to central bank interventions much more swiftly. Throughout the crisis ETFs traded at double the volume they did in 2019, albeit at significant discounts. As the US Federal Reserve announced the first round of $500bn (£388.8bn) short-term loans in mid-March, trading levels of passive funds rose to nine times their average level, a report by the Investment Association shows.

While trading in primary markets almost came to a halt, trading of passive vehicles on secondary markets rose to unprecedented highs. “ETFs have provided a source of liquidity and price discovery when underlying market trading was impaired,” the UK fund industry body concluded.

The role of authorised participants in providing ETF liquidity has previously come under fire from the regulator, as there is a lack of transparency on the total number of authorised participants in the market. Based on high secondary market trading volumes, the Investment Association concluded that the network structure of authorised participants has held up well and helped to maintain overall liquidity levels.

The rise in ETF trading volumes was also noted in the Bank of England’s May 2020 Interim Financial Stability Report.

“During the period of market stress in March, unlike in some previous stress events, investors may have found it easier to trade ETF shares than the underlying assets held by the ETF, and trading volumes in ETF shares rose significantly,” the central bank noted.

Fund flow data suggests that the ETF industry emerges from the market upheaval in the first quarter bruised but not beaten. In the first half of 2020, the industry booked €17.4bn (£15.8bn) in net inflows, largely driven by growing demand for bond ETFs (€16.4bn/£14.9bn) as investors attempt to hoard liquidity. A slowdown in demand for equity funds and a sharp decline in the value of the underlying assets meant that the European ETF industry’s assets under management shrunk to €830bn (£755.8bn) by the end of June, a €40bn (£36.4bn) drop year to date, according to Lipper data. Overall, European ETF’s booked €17bn (£15.4bn) in inflows, a sharp reduction compared to the €106.7bn (£97.1bn) they reported in 2019.

Does all this mean that the concerns about the pro-cyclical nature of ETFs were misplaced?

The Bank of England sketches a more cautious picture. Individual investors in ETFs and open-ended funds replicating their allocation may have benefited from a first-mover advantage, the report concludes, but passives remained more sensitive to asset price moves, particularly if the underlying assets are less liquid, the Bank warned.

Bond ETFs did indeed trade at a sharp discount in mid-March, a challenge which was only overcome by large scale central bank interventions, the Bank of England stresses. “The magnitude of the sudden demand for cash could not be fully met by the private sector alone,” it warns, suggesting that the ability of ETFs to perform in times of stress is dependent on central banks stepping in infinitely as a buyer of last resort.

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