How ETFs trade during periods of market stress has been one of the main criticisms thrown at the industry in response to its rapid growth since the Global Financial Crisis (GFC).
The idea that ETFs provide an “illusion of liquidity” and should not offer exposure to less liquid parts of the market is an often-used taunt from the mutual fund industry.
However, academic research from Anna Helmke of the University of Pennsylvania has argued this is simply not the case, a fact known by proponents for the ETF wrapper and regulators alike.
In the research, titled Will ETFs drive mutual funds extinct?, Helmke pointed to the role of authorised participants in providing intraday liquidity in the secondary market while mutual funds guarantee redemption at the end-of-day net asset value (NAV).
“ETFs may be more suited for less liquid index market segments favoured by long-term investors, whereas mutual funds may be a better fit in liquid fund market segments favoured by investors with short-term liquidity needs such as money market funds,” she warned.
In particular, Helmke warned this is because the mutual fund structure and the protection it provides from high trading costs gives rise to “run risks”.
“Mutual funds are an intermediary-based index investing technology as part of which investors co-insure each other against short-term liquidity needs through the guaranteed redemption of fund shares at the end-of-day fund NAV,” the report explained.
“Particularly in illiquid index segments, such as corporate bond or international equity funds, and during periods of market stress, mutual funds’ unique payoff structure shields investors with urgent liquidity needs from potentially high trading costs.
“The costs of mutual funds’ short-term liquidity provision manifest as share dilution and are borne by remaining, long-term mutual fund investors. The resulting payoff complementarities among mutual fund investors give rise to run risks, the key friction associated with this technology.”
Because mutual funds only trade on the primary market, the liquidity mismatch has been clear to see over the years. The high-profile demise of UK star fund manager Neil Woodford is the most obvious example while UK property funds have closed numerous times since the Brexit vote in 2016.
The Woodford scandal led former Bank of England governor Mark Carney to warn mutual funds were “built on a lie”.
“This is a big deal. You can see something that could be systemic,” Carney said. “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally are not liquid.”
As a proponent of the ETF structure, the COVID-19 sell-off in March 2020 provided the perfect case study for investors previously concerned about what would happen to ETFs during a period of market stress.
When liquidity in the underlying fixed income market dried up and bonds effectively stopped trading, ETFs acted as a tool of price discovery by providing investors with real-time pricing while the end-of-day NAVs turned stale.
Highlighting this, the iShares $ Corp Bond UCITS ETF (LQDE) traded over 1,000 times on 12 March while its top five holdings traded an average of just 37 times each, according to data from BlackRock.
Furthermore, the likes of the International Organisation of Securities Commissions (IOSCO), the Bank of England and the International Monetary Fund (IMF) all softened their stance on the systemic risk ETFs pose to financial stability.
Whether this means mutual funds will become extinct is another question. There is certainly no stopping the rise of ETFs, however, structural challenges – especially in Europe – continue to protect the ingrained mutual fund industry.
