Research reveals how liquidity providers stepped up and ETF investors carried on
In many ways, the COVID-19 pandemic was a grand experiment, helping wealth firms realize the benefits of a virtual work model as well as giving insight into people’s actual tolerance for financial risk. And as a new report from the Investment Funds Institute of Canada (IFIC) illustrates, it also presented an opportunity to stress-test Canada’s ETF market.
“Leading up to the COVID-19 financial crisis, some academics and policymakers hypothesized … Liquidity providers (market makers and designated brokers) would step back from their role of making markets, and ETF shares would be redeemed with the associated sale of underlying securities,” IFIC said in a report titled ETF Resiliency in the Covid-I9 Financial Crisis: A Canadian Perspective.
But during the COVID-induced market selloff, when virtually assets saw unprecedented drawdowns and volatility, the report said designated brokers and market makers rose to the occasion, facilitating an increased level of creations, redemptions, and trading activity.
Absolute flow, which measures the dollar value of a market maker’s impact to the underlying bond market, was higher than normal from February to June of 2020. In March 2020, when the selloff was the deepest, absolute flow of corporate bond ETFs accelerated to $1.5 billion, more than double the average value of $600 million seen in prior months, and peaked in the spring.
“The ‘secondary to primary ratio’ for corporate bond ETFs trended downward indicating that almost all the ETF selling pressure was met by ETF market makers buying the ETF shares and processing redemptions,” the report said.
Drawing from an ETFGI analysis of 133 TSX-listed ETFs that track Canadian benchmarks, including 66 equity and 67 bond, the report said the number of market participants reporting ETF trades on the TSX rose from 49, pre-pandemic, to 60 during the COVID period.
And while critics have also warned that external market shocks would trigger a vicious cycle of redemptions and asset price declines in the ETF space, those fears didn’t materialize during the COVID-19 financial crisis.
“[D]espite the extreme stress in the bond market, bond ETF redemptions were modest relative to assets and did not impact underlying markets,” the report said.
Last year, the ratio of secondary market trading volume to total corporate bond trading volume increased to 4%. A spike in ETF trading value, the report added, suggests investors were turning to ETFs as a vehicle to access liquidity.
An analysis by ETFGI determined that during March 2020, average equity ETF bid-ask spreads widened to 1.85 times the average spreads see in the months before the crisis. The underlying basket of securities, meanwhile, saw its average spread increase to 2.36 times the average spread leading up the market event.
And while investors did pull money from bond ETFs during March, April, and May 2020, the report said flows went returned to positive territory in June. Monthly net outflows from bond ETFs in March, April, and May were $1.2 billion, $629 million, and $56 million, respectively; as a percentage of starting assets, they were 1.8%, 0.9%, and 0.1%.
“Investors did not halt their purchases during the most stressed periods,” IFIC said. “In fact, when gross redemptions were at their highest in March 2020, gross sales were also at their highest suggesting that instead of running for the exits, many investors saw the price declines as a buying opportunity.”
