ETFs: the investment vehicle that could move markets

12 October 2020: Large passive managers use ETFs, giving them volume that can make them market movers. Writing for the Financial Services Faculty, Carlos Torneros asks if their behaviour during the pandemic makes them liable for reform.

The market mayhem experienced during the worst times of the COVID-19 crisis served as an unexpected test for the growing popularity of the Exchange Traded Fund (ETF) industry among investors of all risk profiles.

When the pandemic hit, the jury was still out on whether ETFs can contribute to volatility, help create market bubbles and pose system risk. 

Corporate bonds markets were viewed as a bellwether when for several weeks in March they spiralled down as economic activity froze due to lockdown restrictions. 

As a result, ETFs with bonds as underlying securities traded at huge discounts. Media commentators and analysts started to put the spotlight on its resilience, pondering the need for reform and more oversight.

The US Federal Reserve then stepped in buying not only corporate bonds but also bond ETFs. ETF backers have interpreted the US central bank’s move as an endorsement of ETFs, as they would be the best conduit to help struggling bond markets.

Moreover, supporters argued that ETFs acted as a release valve because had they not existed, fund managers would have sold more bonds and the market would have fallen more. 

Critics, however, warned that bond ETFs would fail to live up to their expectations when faced with unfavourable market conditions as they create an illusion of liquidity. Either way, ETFs are tipped to reach more than $12tn in assets under management by the end of 2023. 

Despite their relatively short existence as investment vehicles – the first one was launched in 1993 – its potential could grow more as they still account for only 10% of total equity assets and below 2% for bonds. 

Financial Services Faculty members can read the full feature here.