Today, the TrackInsight research team presents the findings of an article initially published on ETFstream.com by Vincent Deluard, global macro strategist at INTL FCStone.
The study, which looks at six million data points, answers a question that we have had in mind for quite some time at TrackInsight: do ETF flows impact their short-term performance? And if so, can the anomaly be exploited?
Broad take: the systemic risk of ETFs
With the rising popularity of ETFs has come increasing concern that these products pose new risks to market stability and performance. The systemic risk of ETFs has been widely covered by institutional actors such as the European Systemic Risk Board (ESRB) and the CFA Institute.
Evidence suggest that ETF flows have an impact on their underlying securities prices, especially at times of market stress and if the constituent securities are illiquid, through mechanisms such as the co-movement of security prices.
As the European Systemic Risk Board (ESRB) states in its June 2019 report on ETFs, “stocks tend to co-move more with their respective indices once they are included in ETF portfolios. This increase in the co-movement of asset prices may pose systemic stability issues, as it makes it more likely that many investors face losses simultaneously, therefore potentially leading to waves of insolvencies and synchronised sales.”
The study: ETFs flows and performance
Vincent Deluard’s article answers two burning questions:
- Do big ETF outflows create discounts to NAVs?
- Do big ETF outflows create a buying opportunity?
Our TL; DR
- Yes, large liquidations at times of market stress can create discounts to NAVs, and this is especially true for ETFs which lack underlying liquidity, such as smaller high-yield bonds and emerging markets funds. The reason stated being that dealers cannot properly hedge their exposure due to liquidity issues or trading constraints.
- No, big outflows do not automatically translate into a buying opportunity. To quote the study: “For most days and most funds, flows-based short-term trading strategies would have the same probability of success as a coin flip.”
However, acting as a liquidity provider for the ETFs that suffer the most abnormal discount to NAVs in periods of stress can turn out to be a profitable strategy. In this case, as investors buy when everyone is selling, they take on a risk which tends to be compensated: as the study finds out, “most small emerging markets ETFs tend to rebound by 30 to 70 basis points the day following abnormal outflows. [Still,] investors may not be able to capture the full rebound because wider-than-usual spreads will shrink their expected gains.”
Going further: evaluating an ETF’s resilience
The concept which seems key here is the ETF’s underlying liquidity.
We find that it should be assessed with a combination of two metrics:
- The trading volume of the underlying securities: when it is scarce, even liquidating a small position can generate huge losses for the investors
- The ETF control ratio on the underlying securities: when it is significant, even liquidating in relatively liquid markets can generate huge losses for the investors
Going further, it would be interesting to study how both the ETF control ratio and the trading volume of a specific security correlate to the discounts to NAVs in periods of market stress.