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The Road ahead for ETFs After the COVID-19 Crisis
Despite some of the aforementioned market quality and price dislocations during the COVID-19 pandemic, ETFs provided investors with liquidity when they needed it most. A number of institutions — such as central banks, stock exchanges and regulators — were instrumental in ensuring global markets and their infrastructures performed well. With new policies and users entering the scene, the road ahead for ETFs looks promising.
ETFs — A tool for central banks to support the market
ETFs have proven to be an effective tool for central banks to tap into liquidity and support the market. Dating back to 2010, the Bank of Japan (BOJ) purchased ETFs to support the equity markets, without having to transact in individual securities.
In response to the market volatility and liquidity constraints during COVID-19, the BOJ increased its ETF purchases to more than 1.5 trillion yen ($14 billion) in March 2020.
Additionally, on April 30, 2020, the BOJ changed a rule within its program to link its purchases of ETFs to the amount of each stock available in the market. After having announced in 2019 that it would lend their ETF holdings to investors, the BOJ has now taken an additional step to improve liquidity in the market and minimize potential drawbacks to their ETF purchasing program.
Fixed income ETFs added to the Fed’s policy toolkit
On March 23, 2020, in an effort to offer stability and improve liquidity in the corporate credit market, the Fed announced that it would purchase corporate debt through a Primary Market Corporate Credit Facility (PMCCF). The Fed also stated that it would support market liquidity for corporate debt through a Secondary Market Corporate Credit Facility (SMCCF) by purchasing individual corporate bonds and ETFs in the secondary market.
The SMCCF began its ETF purchases on May 12, 2020 through a special purpose vehicle (SPV). The SPV initially received a $25 billion equity investment from the Department of Treasury, which can then be leveraged to a maximum size of $250 billion.
Eligible ETFs for the SMCFF include US-listed ETFs “whose investment objective is to provide broad exposure to the market for US corporate bonds. The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.”1
Exchange enhancements and resiliency
Despite the extraordinary market volatility and liquidity challenges during the COVID-19 crisis, the equity market structure performed well.
In the US, equity market structure enhancements that were implemented following the “flash crash” of May 6, 2010 and refined since the market events of August 24, 2015 helped to ensure that investors were able to trade ETFs with a high degree of confidence during the pandemic. The US equity market-wide circuit breaker mechanism was triggered four times and performed as designed. Additionally, several regulators and stock exchanges around the globe enhanced their processes and implemented new regulations to adapt to the COVID-19 crisis and improve market resilience amid extreme volatility. These changes include:
- Euronext & Nasdaq revisiting their (re)opening process In order to allow the market to open normally while providing participants with the opportunity to absorb incoming news, Euronext widened the volatility thresholds in some of its ETF listings on several days during the month of March 2020. Euronext’s regulators were consulted prior to the actions being taken.
Following the marketwide circuit breaker trading halts in the US, on March 13, 2020, Nasdaq filed a proposal with the SEC to enhance the reopening auction process for Nasdaq-listed securities. The purpose of this enhancement was to align with the process currently employed following a Trading Pause initiated pursuant to the Plan to Address Extraordinary Market Volatility (i.e., the LULD Plan).
- Change in market-making obligations or incentives in London and Frankfurt On March 13, 2020, both market participants and registered market makers received notice from the LSE that in compliance with Rule 4102 of the Rule of the LSE, and taking into consideration global financial market conditions, the maximum spread requirements would be widened to 5% for all Fixed Income ETFs. These changes took effect at market open on March 13, 2020 and were subsequently extended by the LSE on March 16, 2020 to further include all ETFs.
In order to encourage liquidity providers to continue their quotation activities during March 2020’s volatile markets, Deutsche Boerse rewarded them by doubling the achieved performance score during “High Volatility Quotation Days” (as defined by Deutsche Boerse in an external communication). Violations of Designated Sponsor performance requirements were subsequently not sanctioned in March 2020.
- SFC issued guidance on the oversight of ETF market maker activities In Hong Kong, ETF market-making activities by a liquidity provider were temporarily suspended after some traders were forced to undergo mandatory quarantine due to the COVID-19 outbreak. This subsequently raised concerns for the Securities and Futures Commission (SFC) with regard to the secondary market liquidity available to retail investors. The SFC alerted issuers to maintain active dialogue with market makers to gain a better understanding of their setup and make necessary preparations for ensuring business continuity, if and when it had to be activated, with a view to avoiding market disruption.
Overall, the measures implemented by exchanges and regulators were instrumental in promoting fair, orderly and resilient markets during the COVID-19 crisis. In the ETF space in particular, actions taken by exchanges to allow for more flexibility in terms of market-making obligations allowed market makers the ability to continue providing liquidity to investors.
Increased ETF usage in the aftermath of the COVID-19 crisis
The COVID-19 pandemic brought unprecedented challenges to markets across the globe, impacting liquidity across nearly all investment vehicles and asset classes. Despite these challenges, ETFs functioned as designed, providing market participants with liquidity when they needed it most. The staggering trading volumes during March 2020 illustrate how investors gravitated toward ETFs during periods of stress, with US-listed ETFs trading more than $15 trillion during the first five months of 2020, or 70% of their trading volumes in 2019.
- In 2019, ETFs represented 30% of all equity trading volume. SPDR ETFs represented 12%.
- In the first five months of 2020, ETFs represented 33% of all equity trading volume. SPDR ETFs represented 13%.
Given the important role that ETFs continue to play in providing liquidity and price transparency to the marketplace, particularly during stressed markets, we expect to see ETF adoption continue to rise and assets continue to grow.
1Federal Reserve Bank of New York as June 15, 2020.
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.
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.
Equitizing Cash
Equitizing cash is putting cash or equivalent assets to work in the stock market, often temporarily, with relatively liquid vehicles, including ETFs.
ESG Investing, or Environmental, Social and Governmental Investing
A set of criteria that investors can use to screen investments. Environmental criteria look at how a company performs as a steward of the natural environment; social criteria examine how a company manages relationships relevant to its operations; and governance criteria deal with a company’s leadership, executive pay, audits and internal controls, and shareholder rights.
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.