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SPDR ETFs: Liquidity Buffers in Volatile Markets
In 1993, State Street Global Advisors launched the first US-listed exchange traded fund (ETF) to help stabilize markets and improve liquidity during periods of market turbulence. During recent market volatility, ETF trading volume surged relative to overall market volumes, highlighting that ETFs continue to function as intended — as buffers and sources of liquidity in stressed markets.
ETFs: Born in crisis and serving their purpose through crises
In order to understand and evaluate the performance of ETFs during the COVID-19 crisis, it is worth taking a moment to remind ourselves of why and how ETFs first came into being.
ETFs were created as a response to the US stock market crash on October 19, 1987, commonly referred to as “Black Monday.” The US Securities and Exchange Commission’s (SEC’s) Division of Market Regulation, in its post-mortem report analyzing the market events of October 19, 1987, found that the systematic selling of stock-index futures by institutional investors had exacerbated the market selloff, and suggested examining whether market basket trading could help stabilize markets in the future. Specifically, the report suggested that consolidating stock basket trading to a single post “could provide an additional layer of liquidity to the system and cushion somewhat the individual stocks from the intraday volatility caused by program activity.”1 In collaboration with State Street Global Advisors, the American Stock Exchange harnessed this idea, which culminated in the launch of the first US-listed ETF in 1993.
More than 27 years later, ETFs have grown into a multitrillion dollar industry, with assets under management (AUM) more than $5.8 trillion as of May 2020.2 More than 7,000 ETFs — utilized by retail investors, institutional investors, asset managers, insurance companies, sovereign wealth funds, and private banks — now trade across many exchanges around the globe. Today, investors use ETFs for a variety of purposes including strategic or tactical asset allocation, cash equitization, transition management, and portfolio hedging, to name just a few. One of the most valuable characteristics of the ETF wrapper is its ability to provide transparent exposure and liquidity to the marketplace throughout the trading day.
The market volatility during the COVID-19 crisis tested, yet again, the efficiency of the ETF wrapper and its additive liquidity to the marketplace. In the US, on March 12 and 16, 2020, two of the worst days for the S&P 500® Index since 1987, SPDR ETFs traded more than $100 billion, accounting for more than 16% of US equity market trading volume, demonstrating their utility during a period of extraordinary market volatility.3
Record ETF trading volumes
Globally, ETFs reached record trading volumes in March 2020. As illustrated in Figure 2, ETF trading volumes were heavily skewed toward US-listed ETFs, whose volumes reached record highs. US-listed ETFs traded more than $5.3 trillion in March 2020, well above the previous monthly record of $3.0 trillion set during the stock market selloff in October 2018. In addition, US-listed ETFs traded another $3.0 trillion in April 2020 and $2.4 trillion in May 2020. EMEA4,6-listed ETFs and APAC5-listed ETFs also experienced a surge in trading volumes in March 2020.
Important to note, ETF trading volumes represented more than 39% of US equity market volume in March 2020. In comparison, in 2019, ETFs represented 30% of trading volume, suggesting an increase in ETF usage as clients gravitated towards ETFs for exposure, liquidity, and potentially even price discovery during a period of extraordinary market stress. This increase in ETF usage was not limited to the US, with EMEA4,6 and APAC5 regions both seeing an increase in ETF volumes relative to common equities.
Correlation between ETF trading volumes and volatility
During the extreme market volatility in March and April 2020, investors turned to ETFs as efficient tools to express market views and implement trading strategies. Unsurprisingly, ETF trading volumes in the US were highly correlated with the heightened volatility.
This underscores the additive liquidity provided by ETFs during periods of market stress, leading to a significant increase in ETF trading volume across several market segments. The SPDR ETF suite traded, on average, more than $109 billion on days when the CBOE Volatility Index exceeded 60, a level not seen since the Great Financial Crisis of 2008–2009.
ETFs act as liquidity buffers
Although ETFs recorded record-high trading volumes in March 2020, only a portion of secondary market volumes resulted in primary market activity. For example, Figure 5 and 6 indicate that:
- Gross primary market flows on these ETFs represented less than 7% of the trading volume of common stocks in the US on every US trading day in the first five months of 2020
- US-listed U.S. Equity ETF trading volumes represented, at times, more than 50% of the trading volume of common stocks in the US
Overall, the data suggests that ETFs trading volumes resulted in very little primary market activity. The secondary market provided market participants with an additive layer of liquidity, potentially resulting in less stress on individual securities.
It’s also important to take a look at fund flows during the market selloff in March 2020. As you can see in Charts 7 and 8, ETFs flows paled in comparison to those of Mutual Funds in the US, likely resulting in far less trading in the underlying securities.
Especially in volatile markets, SPDR ETFs have served as effective price discovery tools. Learn more about using ETFs to assess the valuation and liquidity of the overall market.
1October 1987 Market Break report by the SEC Division of Market Regulation.
2ETFGI LLP, as of May 2020.
3ETFs and Common Stocks listed in the US.
4EMEA includes listings on the London Stock Exchange, Deutsche Boerse, Euronext Paris, Euronext Amsterdam, SIX Swiss Exchange and Borsa Italiana.
5APAC includes listings in Japan, Mainland China, Hong Kong S.A.R., Taiwan, South Korea, Singapore and Australia.
6A majority of the ETF trading activity happens outside of stock exchanges in EMEA.
7US-listed U.S. Equity ETFs.
Basel Accord
The three sets of banking regulations — Basel I, Basel II and Basel III — set by the Basel Committee on Bank Supervision (BCBS), which provide recommendations on banking regulations related to capital risk, market risk and operational risk. The purpose of the Basel agreements is to ensure that financial institutions have enough capital on hand to meet obligations and absorb unexpected losses.
Beta
Measures the volatility of a security or portfolio in relation to the market, with the broad market usually measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
CBOE VIX Index
A measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
Creation/Redemption Mechanism
The process by which ETF shares are created and redeemed. The creation process involves authorized participants (APs) buying underlying shares and delivering those shares to the fund sponsor in exchange for equally valued ETF shares. The redemption process is the reverse, wherein the AP removes ETF shares from the market and exchanges those ETF shares with the ETF sponsor for an equally valued amount of the ETF’s underlying shares.
Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer ProtectionAct, enacted on July 21, 2010, places strict regulations on lenders and banks in an effort to protect consumers.
Equitizing Cash
Equitizing cash is putting cash or equivalent assets to work in the stock market, often temporarily, with relatively liquid vehicles, including ETFs.
Transparency
A term that describes the extent to which investors have easy access to objective financial information about companies or funds such as ETFs. Those data include price movements, market depth and audited financial reports.
Investing involves risk including the risk of loss of principal.
State Street Global Advisors and its affiliates (“SSGA”) have not taken into consideration the circumstances of any particular investor in producing this material and are not making an investment recommendation or acting in fiduciary capacity in connection with the provision of the information contained herein.
The views expressed in this material are the views of SPDR Americas Research and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.” Brokerage commissions may apply and would reduce returns. Please see the fund’s prospectus for more details.
Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
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. Diversification does not eliminate the chance of experiencing investment losses.