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Policymakers should re-examine the risks posed by exchange-traded funds during times of stress, according to the IMF, even though the vehicles are less of a concern than their open-ended mutual fund counterparts.
The authors of the IMF’s recently released Global Financial Stability Report expressed their deepest concerns about mutual funds exposed to illiquid bonds, calling on policymakers to ensure that funds use adequate liquidity management tools .
However, he also said that policymakers “should analyze exchange-traded funds further.”
“The provision of intraday liquidity by ETFs makes them attractive to short-term liquidity traders. Together with the arbitrage activities of authorized participants who create and redeem ETF shares, this facilitates the transmission of non-fundamental shocks from short-term cash traders to securities markets,” the IMF report states, referring to research on equity ETFs published in 2018.
“Consistent with this transmission, ETFs can increase non-fundamental volatility in asset markets and amplify the sensitivity of cross-border capital flows to global financial conditions,” the report said.
The authors also note that in the case of emerging markets, the importance of benchmark-driven portfolio flows has increased significantly over the years. They argue that this poses additional risk as these flows tend to be highly sensitive to global factors, potentially increasing the risk of excessive outflows during times of market stress.
However, industry figures said the IMF’s concerns were overblown.
MJ Lytle, managing director of Tabula Investment Management, a bond ETF specialist, said that while it was understandable for the IMF to highlight all known concerns, in reality the ETF envelope had proven to be very robust, for example during the market crash that accompanied the onset of the Covid pandemic in March 2020.
Lytle argued that ETFs had shown that their create-redemption mechanism made them a better vehicle for liquidity-conscious investors.
“If you care about liquidity and you are in a vehicle that says it offers daily liquidity but cannot offer it [such as an open-ended mutual fund with illiquid holdings during times of market stress]there should be stricter requirements,” Lytle said, pointing out that long-term investors in mutual funds bear the trading costs of those entering and exiting the vehicles.
Kenneth Lamont, Senior Fund Analyst for Passive Strategies at Morningstar, confirmed: “Proponents of traditional active management with an ax to grind have long warned of the ‘ticking time bomb’ of liquidity in ETFs. And yet, when put to the test, the structure performed admirably time and time again,” Lamont said.
“The built-in market maker process means that certain ETF transactions can be cleared without buying or selling the underlying assets, a benefit that is not open to most equivalent managers of traditional mutual funds,” pointed out Lamont, adding that this allowed ETFs to effectively become price discovery vehicles in March 2020 – continuing to trade even if the underlying market had seized up.
This price discovery benefit was also noted by Carolyn Weinberg, global product manager, iShares and index investing, at BlackRock.
“Fixed income ETFs have been tested in many stressed market scenarios and proven to offer price discovery and the ability to access liquidity in volatile markets,” Weinberg said.
Lytle argued that there was no perfect mechanism for trading securities, but ETFs made more sense. He pointed out that most ETFs are passive index trackers, which have certain advantages in times of market stress. ETFs that track passive benchmarks aim to minimize tracking error in all environments, which means they would not skew towards selling liquid assets before less liquid ones.
It also means that they would try to sell a perfect slice of the fund against any redemption.
“I don’t think ETFs are a panacea for all problems. But I think the creation-redemption mechanic makes a lot more sense,” Lytle said.
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