Commonly asked questions about ETFs during volatile markets

The coronavirus pandemic has caused significant volatility in financial markets.  Global equity benchmarks fell from record highs into a bear market in a matter of weeks. The Cboe Volatility Index, an index which looks at share market volatility, increased to its highest level since 2008. Fixed income markets were impacted by moves in interest rates as central bankers sought to mitigate the virus’s economic impact.

Market volatility of this magnitude has few precedents within the past century. It’s notable that in this environment, ETF volumes have increased markedly, as a large number of investors turn to exchange traded funds (ETFs) to express their view and adjust positions. Several metrics indicate that ETFs have held up comparatively well during the heightened volatility, with investors using ETFs to help manage risk in challenging market conditions.

How have iShares ETFs traded in the recent market conditions?

Our ETFs have continued to trade and to date have provided access to liquidity in volatile markets.  Whilst the spreads in some of our ETFs have widened, our panel of external market makers have continued to be active. Wider spreads on certain funds can be attributed to (1) increased volatility in equity & bond markets and (2) a different operating environment for market makers – which has implications for the hedging of their positions.   Wider spreads are to be expected in certain trading environments, and overall the ETF ecosystem has continued to operate as expected, with our market makers providing liquidity.

Understanding ETF Liquidity

Exchange-traded funds (ETFs) are unique; they provide exposure to a diversified collection of assets, like a managed fund, but trade on exchange, like a stock. This structure makes the liquidity of ETFs unique, too. Liquidity refers to the ease of buying or selling a stock, and ETFs provide two layers of liquidity to the market.

The first is primary market liquidity, which is provided by the underlying securities or instruments of the ETF. The second layer is secondary market liquidity, which is provided by the ability to trade ETFs on exchange. This means that ETFs are net contributors to market liquidity. At a minimum, an ETF will be as liquid as its underlying securities or instruments; often, however, ETFs may provide even greater market liquidity than their underlying instruments. This is demonstrated below using our ASX listed iShares S&P 500 ETF (IVV) and its trading over this volatile period (as of 20 March 2020).

Understanding ETF Liquidity

Best practices when trading ETFs

Order Type

Make sure your order type is consistent with your goals. To help protect against swings, consider using limit orders (especially in volatile markets). 

Time of Day

Markets can often be more volatile near the open and close, and the efficiencies of ETF arbitrage are less relevant in the “Market on Open” and “Market on Close” auctions. Consider trading after the first, and before the last, 20 minutes of the trading day. Consider underlying market opening hours as this could impact the pricing and liquidity of the ETF.

Knowledge of Underlying

ETFs offer exposure to multiple asset classes and regions - be mindful of the underlying’s market hours, holiday closures trading dynamics.

Just like trading individual stocks, make sure that your order type is consistent with your risk and appetite and investment goals:

1. Limit order

The order is executed only at the price specified, or better. This aims to avoid an unexpected or undesirable outcome at times of higher market volatility or potential wider spreads. A limit order will not be executed unless the order price specifications can be met.

2. Market order

The order executes as soon as possible at the best price available at the time. However, all or part of the trade is at risk of being traded at a value different from the last traded price especially in times of market volatility or lower liquidity

Due to the execution price risk of a market order, limit orders are generally considered to be preferable in most circumstances but note that if the limit order cannot be filled in the market, your order will not be executed.

Detailed comparison of order types