The case for ETFs as market stabilizers


ETFs are widely recognized as funds that offer investors a number of attractive features, including diversification, flexibility, transparency and low costs. However, what may be lesser known is how ETFs positively impact financial markets.

November 2023

Matthew Bartolini
Head of SPDR® Americas Research
State Street Global Advisors

Frank Koudelka
Global Head of ETF Solutions
State Street

Robert Forsyth
Head of ETF Strategy and Research
State Street

Colin Ireland
Head of SPDR Institutional Strategy
State Street Global Advisors

Take liquidity, for instance. ETFs are used to make real-time asset allocation decisions and provide liquidity at a time when investors demand it the most. A close examination of the impact and liquidity trends of ETFs during crisis events since the industry originated 30 years ago shows how they can act as market stabilizers as well.

COVID-19 crisis test
One recent example of the positive impact of ETFs on markets was during the onset of the COVID-19 pandemic. At that time, increased volatility and uncertainty manifested in broad-based de-risking, triggering a rush to sell all kinds of assets. 

At the start of the pandemic, with volatility increasing, investors gravitated toward ETFs based on the availability of on-screen liquidity of the products. This led to a substantial increase in trading volumes across a multitude of market segments. ETF secondary market volumes, in particular, reached a daily high-water mark of US$397 billion. For seven days, it marked above US$268 billion — the previous record set in February 2018.1 ETFs acted as the price discovery tool for investors, particularly in the fixed-income market, where market participants faced challenges finding liquidity and establishing pricing for individual bonds. 

Subsequently, ETFs traded with the largest value ever over a 10-day period (US$1.4 trillion) in the United States. This is a calendar-year record for average daily volume of US$128 billion a day in 2020 — a 31 percent increase from the record set in 2018.2

Beyond high notional figures in 2020, the share of the trading volume on US exchanges for ETFs has also increased. Over the past 15 years, especially during the last five-year period, ETF trading volumes have accounted for an average of 28 percent of all exchange volume.3 However, from February to April 2020, there were 36 consecutive trading days where ETF volumes represented more than 30 percent of tape volumes (peaking at 41 percent) — the longest streak since the Global Financial Crisis.4

Fixed-income ETFs also allowed investors to tactically seek market access as a result of a change in sentiment. After the Federal Reserve’s (Fed’s) policy actions on March 23, 2023 to stabilize the market, there was an unprecedented influx of investment-grade and high-yield ETFs in the following months — the most ever in any 60-day period in history. These strong flows were one of the reasons why both segments posted record annual flows in 2020 (US$59 billion and US$21 billion, respectively) as investors used ETFs to efficiently execute broad macro asset allocation changes. 

In our view, the Fed itself turned to ETFs as a way to efficiently and quickly allocate capital into the credit markets across a broad set of issuers (i.e., avoiding single-issuer risk or presence of favorable treatment) in a transparent manner. Under the Federal Reserve Secondary Market Corporate Credit Facility (SMCCF), the Fed was able to inject liquidity into the corporate bond market by using ETFs that seek to provide access to a diverse set of firms all through a single, transparent and liquid investment. However, despite their publicized actions, the Fed accounted for just 7 percent of fixed-income inflows during its purchasing period.5 This illustrates that in 2020, bond ETFs were sought after by more than just the central bank for achieving specific portfolio objectives. 

Overall, this shows how, as market concerns rose, traders, central banks and investors used ETFs to fine-tune portfolios, transfer risk and seek liquidity and hedge exposures — all at record volumes — rather than flee from it. Further data shows the average number of registered market makers and other liquidity providers increased during the time of market stress compared to normal periods.6

In the end, ETFs amassed more than US$500 billion of inflows as a result of all of this usage in a time of crisis. 

Regional banking crisis test
ETFs create additional liquidity because they are traded in the secondary market between willing buyers and sellers at a fair market price that doesn’t always require direct involvement with the underlying portfolio. In most cases, the secondary market demand for shares is met by the current supply of shares, without a market marker or authorized participant (AP) having to create more shares to meet that demand.

The additive liquidity can be measured by comparing secondary market trading volumes to primary market transactions. Given that primary market transactions (e.g., fund flows) can be positive and negative, we need to evaluate the absolute value. Typically, this ratio for all ETFs is 8:1, indicating that for every US$8 traded on the secondary market, only US$1 hits the primary market (the fund).7 For financial sector ETFs, the one-year average ratio was 8.5:18 prior to March 2023. Yet, from March 8 to 16 – during the onset of the regional banking crisis – that ratio increased to over 15:1 as investors reacted to the bank failures.

This spike in secondary trading relative to primary activity signals that investors were able to effectively “meet on exchange” and transact, even as the underlying securities were facing extreme uncertainty. This demonstrates how secondary ETF trading provides additive liquidity for investors.

From a flows perspective, the total flows increased, but not on a one-for-one basis to the volumes, given the additive layer of liquidity mentioned above. In fact, net flows during this time were positive, as investors actively sought targeted financial exposure – with one fund posting a record single-day inflow of more than US$1 billion on March 13.9

These positive flows reflect how investors use ETFs as tactical instruments to quickly access a diversified basket of banking stocks in a single trade. Even though primary market activity was elevated, the amount of buying and selling stocks to facilitate ETFs’ creation and redemptions as a percentage of the underlying stocks’ trading volume was low.

ETFs defy skepticism with impressive results
Along the way, as the ETF industry grew, skeptics raised concerns about liquidity. They implied that with so much money indexed to the same securities, serious liquidity problems could arise in a sell-off with negative implications for market stability. However, the reality was the inverse. As a result, the additive liquidity benefits that ETFs have provided during recent crises should build confidence in their structure, and encourage more investors to adopt ETFs in the pursuit of wider objectives.


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