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How ETFs trade during times of market stress has been one of the main criticisms leveled at the industry in response to its rapid growth since the Global Financial Crisis (GFC).
The idea that ETFs provide the “illusion of liquidity” and should not provide exposure to illiquid parts of the market is a common derision in the mutual fund industry.
But an academic study by Anna Helmke of the University of Pennsylvania argues that this is simply not the case, and both ETF wrapper proponents and regulators know this.
In a study titled Will mutual funds disappear because of ETFs?Helmke pointed to the role of authorized participants in providing intraday liquidity in the secondary market while mutual funds guarantee redemption at end-of-day net asset value (NAV).
“ETFs may be better suited to the less liquid index market segment preferred by long-term investors, but not to the liquid fund market segment preferred by investors with short-term liquidity needs, such as money market funds. “Mutual funds may be a better option,” he cautioned. .
In particular, Helmke warned that this is because the structure of mutual funds and the protection from high transaction costs they provide creates “execution risk.”
“Mutual funds are an intermediary-based index investment technology in which investors insure each other against short-term liquidity needs through guaranteed redemption of fund shares at the closing fund’s NAV.” The book explains.
“Especially in illiquid index segments such as corporate bonds and international equity funds, and in times of market stress, the unique payoff structure of mutual funds makes investors in dire need of liquidity vulnerable to potentially expensive transactions.” Save yourself from costs.
“The cost of short-term liquidity provision for mutual funds is manifested as equity dilution and is borne by the remaining long-term mutual fund investors. As a result, the complementarity of interests among mutual fund investors creates run risk, This is the main friction associated with this technology.”
Because mutual funds trade only in the primary market, the liquidity mismatch has been evident for many years. The high-profile death of star British fund manager Neil Woodford is the most obvious example of a number of closures of British property funds since the 2016 Brexit vote.
In the wake of the Woodford scandal, former Bank of England governor Mark Carney warned that investment trusts were “built on lies”.
“This is a big deal. We can see that it could be systemic,” Carney said. “These funds are built on the lie that they can provide daily liquidity for essentially illiquid assets.”
As a proponent of ETF structures, the March 2020 COVID-19 crash provided a perfect case study for investors who have long been concerned about what happens to ETFs during periods of market stress. .
When liquidity in the underlying bond market dries up and bonds effectively cease trading, ETFs provide a platform for price discovery by providing investors with real-time pricing while the closing price is stale. It served as a tool.
Underscoring this, the iShares $Corp Bond UCITS ETF (LQDE) had more than 1,000 trades on March 12, according to BlackRock data, but the top five stocks Each averaged just 37 trades.
Furthermore, the International Organization of Securities Commissions (IOSCO), the Bank of England, the International Monetary Fund (IMF) and others have softened their stance on the systemic risks ETFs pose to financial stability.
Whether this means the extinction of investment trusts is another question. While the rise of ETFs is certainly unstoppable, structural challenges, particularly in Europe, continue to protect the deep-rooted mutual fund industry.
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