Vanguard: How ETFs Trade In Volatile Markets

July 02, 2018

[This ETF Industry Perspective is sponsored by Vanguard.]

Recent volatility in global markets provides a great opportunity to examine how ETFs trade during times of market stress—an increasingly important consideration given the rising popularity of ETFs.

During the week of February 5, measures of broad equity market volatility nearly tripled after many months of relative calm.1

ETFs are no stranger to market volatility. They have survived several market disruptions, including the 2008 global financial crisis. During those periods, they tracked the value of their underlying portfolios, gained in assets and trading volume, and provided low-cost access to a variety of asset classes for millions of investors.

Still, concern among some investors over liquidity during volatile periods remains. To be sure, avoiding trading on days of heightened volatility is one way to steer clear of market uncertainty.

But for investors who must trade when markets are turbulent, let’s look first at how ETFs performed during the recent volatile period and then consider how advisors can help ensure a positive trading outcome for their clients during volatile times.

ETF trading surges during volatile times
ETFs, unlike conventional mutual funds, trade on an exchange, providing intraday liquidity for those investors who want or need to trade.

Intraday liquidity across the entire equity market has tended to spike during large swings in the market—and that includes episodes of volatility. For example, average daily volume in U.S.-listed equities soared to roughly $600 billion during the week of February 5, up from its previous three-month average of $315 billion.2

The figure below shows the spike in volume for equity and fixed income ETFs for that week. The takeaway is that investors who had to buy or sell ETFs during the recent turbulence found a deeper secondary market than usual— a clear positive.

ETFs act as shock absorbers
Vanguard research has shown that from 2012 to 2015, the median daily ETF volume that resulted in a creation or redemption was 6% for equity ETFs and 17% for fixed income ETFs.

In other words, for every $1 of trading volume, only 6 cents for equity ETFs and 17 cents for fixed income ETFs resulted in a creation or redemption. Most ETF transactions took place in the secondary market.3

Average daily value traded across U.S.-listed ETFs during the week of February 5, 2018, versus the prior three-month average

Source: Vanguard calculations, based on data from Bloomberg and Cboe.
Notes: The volumes for equity and fixed income ETFs do not sum to the total for U.S.-listed ETFs because the total includes asset classes not shown here. The week of February 5 includes data through February 9; the previous three months include data from November 3, 2017, through February 2, 2018.

1 The average value of the VIX Index, a widely referenced gauge of market volatility, was 11.1 in January 2018. During the week of February 5, 2018, it was 31.5.
2 Vanguard calculations, based on data from Cboe.
3 Vanguard, 2015. Exchange-traded funds: Clarity amid the clutter. Valley Forge, Pa.: The Vanguard Group.

 

Drilling more deeply into the recent experience, the figure shows that in volatile markets, ETFs act as “shock absorbers,” soaking up even more volume in the secondary market than usual, reducing the impact on the underlying portfolio. This spike in secondary volume keeps downward pressure on the bid-ask spreads that investors pay to transact, and it also helps prevent costly turnover in the underlying portfolio, which can occur when transactions require underlying stocks and bonds to fulfill creations and redemptions.

Limit orders and other alternatives can protect investors
Even though ETFs remain liquid and tradable during volatile periods, wide market swings can cause ETF prices to move sharply. These swings can lead to wider bid-ask spreads or larger premiums and discounts to NAV, both of which can add to the costs of trading ETFs.

The figure below shows that the volume-weighted average bid-ask spread across the ETF industry during the early February spike in volatility was largely in line with spikes in volatility in the past few years. The next figure tells a similar tale regarding premiums and discounts, which can be larger in magnitude in roiled markets and give traders incentive to create or redeem shares. But as the chart indicates, the range of premiums/discounts was also modest by historical standards during the volatile period earlier this year.

Still, leery investors can protect themselves from wider trading spreads or large premiums to NAV by using limit orders, which enable them to set the price at which they are willing to buy or sell an ETF.

These orders prioritize price certainty over execution certainty, presenting a trade-off for some investors who absolutely must complete a trade.4

 

ETFs as shock absorbers: During volatile times, ETF trading surges relative to primary-market creation/redemption activity

Source: Vanguard calculations, based on data from Bloomberg and Cboe.
Notes: ETF volume is defined as the average daily value traded for all U.S.-listed ETFs, while ETF flow is the absolute value of net creation/ redemption activity. The week of February 5 includes data through February 9, 2018, while the previous three months include data from November 3, 2017, through February 2, 2018.

4 Joel M. Dickson and James J. Rowley Jr., 2014. ‘Best practices’ for ETF trading: Seven rules of the road. Valley Forge, Pa.: The Vanguard Group.

ETF bid-ask spreads simply reflect uncertainty in the marketplace
Trailing five-day volume-weighted average bid-ask spread for U.S.-listed domestic equity ETFs

 

ETF premiums simply reflect uncertainty in the underlying portfolio
Range of premiums/discounts across the 25th to 75th percentiles of U.S.-listed domestic equity ETFs from January 1, 2005, through February 15, 2018

Source: Vanguard.

Investors have choices
Investors’ experience with ETFs will largely reflect the underlying market conditions. When compared with conventional mutual funds, ETFs provide more intraday transparency into their underlying portfolios. If transaction costs in the portfolio are increasing because of uncertainty and volatility in the marketplace, an ETF’s price will reflect this.

While volume tends to be available for investors who want to transact during volatile times, cost-conscious, long-term investors who are concerned about bid-ask spreads and premiums have a straightforward defense:
Avoid trading during times of market uncertainty, or alternatively, use limit orders to protect themselves if they do trade.

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For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call
800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

© 2018 The Vanguard Group, Inc. All rights reserved.

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