ETF Market Realities

Answers to 10 popular questions about ETFs

1. How do ETFs impact market 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. ETFs have two layers of liquidity: primary market liquidity, which is provided by the underlying securities or instruments of the ETF, and 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 provide even greater market liquidity than their underlying instruments through their secondary market trading.

2. Do ETFs drive the direction of markets?

Given the size of some of the largest ETFs, one might think that buying and selling within those funds actually moves market prices. In fact, asset allocation decisions made by asset owners, such as pension funds and individuals, drive flows into different asset classes, sectors, and geographies. Their allocation decisions are guided by factors such as macroeconomic developments (like global interest rate policy), risk preferences, and investment horizon. ETFs are just one way for investors to express their views about the market. If ETFs didn’t exist, investors could use other tools, like single stocks, mutual funds and derivatives.

3. How big is the ETF market?

As of April 2020, , there were US$5.8 trillion of ETF assets worldwide.1 Equity ETF assets represent approximately 6.4% of the global equity market capitalization, or dollar value of the global equity market. 2 Even within the United States—the largest ETF market—ETFs are only a fraction of the total financial market. Just 9% of the total assets invested in U.S. equities are in U.S.-listed equity ETFs.3 In Australia, Australian listed equity ETFs represent less just over 4% of the equity capitalization,4

How big is the ETF market

4. Do ETFs increase market volatility?

No. In fact, ETFs have acted as “shock absorbers” during many volatile trading sessions as buyers and sellers transact on the exchange, at real-time prices, without having to trade the underlying stocks and bonds. What’s more, since ETF shares are traded directly by buyers and sellers on-exchange, an ETF can circumvent “forced selling”, something a managed fund may need to do when investors want to sell their shares. This means the underlying securities may remain intact.

5. Are all exchange traded products the same?

While all exchange-traded products share certain characteristics, some have embedded structural risks that go beyond the scope of “plain vanilla” ETFs. BlackRock defines an ETF as a publicly offered investment fund that:

  • Trades on an exchange.
  • Tracks underlying securities of stocks, bonds or other investment instruments.
  • Does not seek to provide a leveraged or inverse return

Investors need to understand what they own. BlackRock, along with others in the industry, has called for a clear-cut ETF naming convention to better serve investors.

6. Do index rebalances make index investing less efficient?

Indices are periodically rebalanced as changes in market prices affect the relative weightings of individual securities. Funds that track indices are professionally managed, and there’s a lot of work that goes on behind the scenes by skilled professionals to make sure these publicized events are smoothly executed.

  • Some funds use knowledge of the indexing process to capture price movements or lessen any temporary price effects by trading in names added to the index. Others may try to capture information by predicting inclusions and deletions.
  • Competition ensures any indexing effects are modest, however. It is not easy to beat index benchmarks.

7. Does index investing increase asset price correlation?

Correlation measures the degree to which two securities’ prices move in relation to one another. Correlation between stocks has risen in recent years, giving rise to a misperception that the growth of index funds is the cause; in other words, that the unique, fundamental drivers of individual stock prices are being superseded by their inclusion in an index. (See question #2)

In reality, correlation isn’t the same as causation. Stock correlations in the US (the biggest ETF market) actually decreased between 2015 and 2017—a period when index funds were achieving record growth.5

There are other, more plausible causes for increased correlations in stock and other asset prices, including macroeconomic factors, like global interest rate policy or the price of raw materials, which can cause asset prices to move in tandem, and heightened market volatility, as we saw during the 2008 Financial Crisis.

8. How do ETFs impact stock prices?

Questions sometimes arise about whether ETFs influence the prices of the stocks they hold. In short, the majority of ETF activity doesn’t affect the market prices of underlying stocks.

This is because generally most of the  ETF activity takes place on-exchange between buyers and sellers of ETF shares, which means that, most of the time, shares of underlying stocks do not need to be bought or sold to adjust for changes in investor demand.

9. What would happen if an authorized participant or market maker withdrew from the ETF market?

An authorized participant (AP) is a financial institution that manages the creation and redemption of ETF shares in the primary market. Each AP has an agreement with an ETF sponsor that gives it the right (but not the obligation) to create and redeem ETF shares. APs may act on their own, or on behalf of market participants.

Market makers are broker dealers that regularly provide two-sided (buy and sell) quotes to clients. In some instances, an ETF’s market makers may also be APs.

APs and market makers operate in a highly competitive environment, and are economically incentivized to take part in making or trading ETF shares. If an AP were to withdraw from the ETF market, other APs would likely step in to facilitate the creation and redemption of ETF shares, particularly if there was a significant premium or discount to its net asset value (NAV), or difference between the price of the ETF and its underlying holdings. In that case, the remaining APs would take advantage of arbitrage opportunities arising from that difference. That same incentive holds true for market makers as well.

Ultimately it is this “arbitrage mechanism” that helps keep the ETF’s market price close to the value of its underlying holdings each day.

10. What role do ETFs play in price discovery?

Price discovery helps investors identify the proper market price of securities or other instruments based on factors like supply and demand. The on-exchange trading of ETFs plays an important role in price discovery across markets, sectors and individual stocks. For example, international ETFs traded during Australian market hours help investors set prices daily when non-Australian markets are closed. Additionally, during suspensions of international stocks or markets, Australian domiciled ETFs may be the in time zone primary source of pricing information available to market participants.

ETF flows provide crucial information. As greater numbers of sophisticated investors use ETFs to express their views, flows from one asset to another can serve as indicators of investor sentiment about potential risk and return.

Note that ETFs don’t set prices or drive volatility. They hold up a mirror to what investors are thinking.

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