“It is our members’ view that ETFs have proven themselves resilient despite the initial market shock and that they have provided a key source of liquidity and price discovery during the crisis,” wrote the Investment Association in June.
We would certainly agree with that conclusion, but the question of liquidity is worth exploring in greater detail.
On the one hand, ETFs have attracted phenomenal inflows this year. In the calendar year to the end of July, a net $35.6 billion was allocated to ETFs in Europe, according to ETFGI. As at that date, Europe’s ETFs held $1.08 trillion of assets under management.
Yet despite this size – and the vast majority of the underlying exposure being to highly liquid securities – questions about the liquidity of the ETF market persist. There are two different aspects to these concerns.
The first is that the liquidity is somehow only ‘one way’: that there is liquidity for inflows, but that it may dry up for outflows. This tends to be raised more in relation to fixed income than equity ETFs, as many bonds don’t trade as frequently as stocks.
Two points should be emphasised in response to this. One is that the ETF structure inherently provides a number of layers of liquidity, so investors don’t need to access the primary market – where the underlying bonds and stocks are traded to meet redemptions (or creations) – for secondary market liquidity, where they sell their ETF units to other market participants without the underlying securities being traded.
If these top two layers of liquidity in the secondary market were illusory or unreliable, they would have disappeared during the stresses of the first quarter. This takes us to the second point: ETFs passed their bear test, as I explained at the time.
The other aspect to this conversation is that while liquidity may exist, it is not always transparent – particularly in that middle layer of off-exchange liquidity in the secondary market. Here, we have more sympathy with the concerns.
As highlighted in a PwC report over the summer, two years after Mifid II came into force – which was supposed to address this matter – Europe still lacks a consistent and comprehensive system for reporting ETF trading. There are undeniable obstacles to creating such a database. For example, PwC noted that more than 70% of European ETFs are listed on two or more exchanges, with over 200 trading venues across the continent, so joining and aggregating all that information is a technical challenge.
Then there is the commercial matter of who would finance this so-called ‘consolidated tape’ in a manner that would make it available to more than just the largest financial institutions.
While European asset managers have called for the European Securities and Markets Authority (ESMA) to finally mandate the creation of a consolidated tape, investors should remember that they have plenty of resources at their disposal to help them better understand the true liquidity of the ETF market. Last year, for instance, I described how capital-markets teams can help investors move in and out of ETFs with much less friction and so save them money.
I have no doubt that Europe’s ETF industry will reach its next trillion-dollar milestone more quickly than the first, not least as ETFs become more integral to the world’s financial ecosystem. Along the way, we will keep looking for ways to make the genuine liquidity in this market more transparent.