ETFs, born from 1987 market crash, are so far making 2020 less awful

Markets are smoother with a buffer.

Financial markets have been terrifying over the past few weeks. But the losses and volatility seen recently don’t come close to Black Monday — October 19, 1987 — when the Dow Jones Industrial Average plunged 22.6% in one day.

In the wake of that carnage, financial regulators decided to create a new product that would help smooth things out. The first exchange-traded fund debuted in 1993, and the ETF industry has exploded since the 2008 financial crisis as investors pour money into a wide array of inexpensive yet out-performing funds.

But the wreckage of the past few weeks is a reminder of what ETFs were originally intended for, and some market participants believe things now would be a lot worse without them. “This is a level of disconnection in the bond market we’ve neeeever seen before,” said Dave Nadig, chief investment officer and director of research at ETF Flows.

Worse than 2008?

“100% worse,” Nadig said. “The market is good at processing risks one at a time. The problem now is we have an energy shock, a global pandemic, the economic impact of both of those things, and on top of that, some of the most aggressive untested moves by central bankers ever.”

As a reminder, ETFs allow investors to express a view on something: large-cap stocks will go up in price, say, or securities from a particular country might not be a good buy right after a populist wins a primary. But unlike mutual fund managers, who buy stocks or bonds or options or other assets, ETFs track — but don’t necessarily trade — those securities.

Related: What is an ETF?

That means more of the trading in “the market” may be expressed through ETFs, as near-proxies of what investors want, rather than in those specific companies or bonds. In early March, iShares, the massive ETF provider, published research that showed that in the last week of February, as volatility started to spike, exchange-traded funds and notes made up 38% of U.S. equity market trading activity, compared to an average of 27% throughout 2019.

Nadig refers to ETFs as a “release valve” for this reason, which has so far been working. “If all this volatility was hitting single stocks, it would be a disaster,” he said. And that tsunami would likely hit the best-known, most liquid companies, such as Amazon.com Inc.

AMZN, +1.23%

and Facebook Inc.

FB, -1.65%

 , Nadig said.

In that way, “ETFs can provide a buffer” for markets, said Richard Daskin, who runs wealth management firm RSD Advisors.

To be sure, through the most recent turmoil there have been some well-publicized dislocations of pricing in ETFs. As MarketWatch reported Tuesday, a large corporate bond ETF closed one recent trading day a bit lower than the value of the securities that underpin the fund. Barron’s has also written recently about such disconnects in other bond funds.

But those hiccups tell us more about financial markets themselves than about the plumbing of fund products, sources told MarketWatch. Not all bonds are frequently traded to begin with, and things get worse in markets gone haywire.

Read: ETFs make the bond market safer, bank analysts say. No kidding, says the ETF industry.

“This problem isn’t emanating out of ETFs. This is a run on the bank amid a collapse in confidence,” Daskin said.

In fact, the argument that ETFs are making things smoother than they would be otherwise is bolstered by another uncomfortable reality of the past few weeks: markets have often been, quite simply, closed. “Circuit breakers” put into place after the 1987 automatically suspend trading whenever certain thresholds are breached.

“Here’s the irony. ETFs have quite literally become the market,” Nadig said. “They are price discovery.”

Market-watchers can use pre-market trading in ETFs to gauge how stock markets may open, if futures trading is halted, or to continue to trade securities in markets that are closed. In January, for example, when China closed its financial markets to contain the fall-out from coronavirus fears, a U.S.-listed ETF with access to Chinese securities that trade on Shanghai and Shenzhen exchanges declined 9.6% from Jan. 23 to Jan. 31.

The Jan. 31 closing price for that fund, the iShares MSCI China A ETF

CNYA, -6.06%

 , “mirrored Monday’s opening prices for mainland China stocks — on Feb. 3, when Chinese stocks reopened for the first time since Jan. 23, the CSI 300 index opened with a decline of 9.1% — nearly identical to what CNYA had foreshadowed,” iShares said in a statement.

See: Trading in S&P 500 ETF implies the stock market may trigger a circuit breaker for the second time this week

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