Do ETFs add Market Volatility?

Exchange traded funds (ETFs) provide investors with robust information on capital flows throughout the trading day. That transparency may actually curb market uncertainty, and help establish new price levels that normalize supply and demand.

Exchange traded funds (ETFs) are funds that trade like individual securities. As with mutual funds, ETFs “wrap” an underlying basket of assets. And like stocks, their shares trade on an exchange. Their unique structure has made them increasingly popular over the past decade, as many investors embrace their versatility and low cost.

However, because exchange traded funds have seen their broadest adoption in just the past few years, it’s worth clearing up some misperceptions that have risen about how these potentially useful tools work and the roles they play in the marketplace.

ETFs are part of a much larger market infrastructure, traded alongside bigger players that are more likely to have an impact.

One mistaken belief is that in a market downturn the frequent trading of ETFs may trigger steeper losses and accelerate shocks. Here’s why that view is turned upside-down, a case of the tail wagging the dog.

  1. ETF size. ETFs are relatively small: Globally, stock ETFs represent some 3% of global equity markets, and bond ETFs only about 0.4% of debt markets.1 In other words, while ETFs are growing, they are part of a much larger market infrastructure, traded alongside bigger players that are more likely to have an impact.

  2. ETF transparency. ETFs reveal information that used to be hidden. Because they are traded throughout the day on an exchange, where their prices are observable in real time by everyone, ETFs continuously communicate investors’ collective views on the markets. This means ETFs sometimes reflect price moves before they can be observed in their underlying basket of securities, which may trade less frequently. While it may seem that the ETF is “causing” the underlying assets to decline, that would be like blaming a light switch for exposing a broken vase on the floor. The ETF is really just reflecting a change in market price sentiment before it is evident elsewhere.

  3. Different types of ETFs. Some concerns have been largely directed at a smaller group of funds such as leveraged ETFs, which have different structural features and behave differently than unlevered ETFs.


1Source: Simfund, BlackRock, Bloomberg, Bank for International Settlements. Global equity market and ETFs as of 6/30/15; global fixed income markets 6/30/14.

During periods of stress, price discovery can help set a market bottom so that trading can normalize. Think of it as an emergency brake on an elevator with a broken cable.

When markets nosedive, setting the brakes

What’s more, ETFs can actually serve as a check on volatility during periods of stress, thanks to their unique structure and the role it plays in balancing supply and demand.

Here’s how ETFs work: ETFs transact in both the underlying market (where underlying assets are exchanged for ETF shares) and on a stock exchange (where ETF shares are traded). In a downturn, when the ETF price declines sufficiently, market participants may buy the ETF shares while selling the underlying assets, aiming to capture price discrepancies – an “arbitrage” process that typically slows the price decline of the ETF’s shares until they are back in line with the value of the underlying assets. (See “Can ETFs help enhance liquidity?”)

When the fund’s share price and the value of underlying assets converge, the market has found a price level at which supply and demand are in balance. Price discovery can help set a market bottom so that trading can normalize. Think of it as an emergency brake on an elevator with a broken cable.

We can see a recent example of the emergency brake at work during the 2013 “Taper Tantrum,” a two-month period when high yield bonds sold off sharply. ETFs not only represented a relatively small portion of outflows, but ETF trading on the exchange also increased the level of liquidity and transparency available to investors.


Sign up for the newsletter