Amid Banking Crisis, ETFs Do Their Jobs

Silicon Valley Bank. Silvergate. Credit Suisse and others. It’s fair to say advisors and clients alike are rightfully concerned about the health of the banking system, particularly at a time when regional banks are asking the Federal Deposit Insurance Company (FDIC) to back deposits for two years.

Clients are fretting about a possible sequel to the global financial crisis and while that scenario might not materialize – hopefully it won’t – it pays for advisors to embrace tools that provide liquidity, particularly at a time when panic selling could emerge.

Exchange traded funds check that box. No, that doesn’t mean equity-based ETFs will rise during times of duress. Specific to the current banking calamity, the Financial Select Sector SPDR (NYSEARCA: XLF) and the SPDR S&P Regional Banking ETF (NYSEARCA: KRE) are lower by 14.32% and 30.73%, respectively, over the past month.

Deep losses to be sure, but ETFs, as they did during the global financial crisis, European sovereign debt crisis and other times of elevated market turbulence, are doing their jobs in terms of providing needed liquidity and functioning as important price discovery tools.

Why Now for ETFs

ETFs have numerous benefits, but focusing on this structure’s utility in volatile market settings, one of the primary perks comes by way of enhanced liquidity attributable secondary market activity.

“In most cases, the secondary market demand for shares is met by the current supply of shares, without a market marker or authorized participant (AP) having to create more shares to meet that demand,” notes Matthew Bartolini of State Street Global Advisors (SSGA). “The additive liquidity can be measured by comparing secondary market trading volumes to primary market transactions. Given that primary market transactions (i.e., fund flows) can be positive and negative, we need to evaluate the absolute value.”

One way of looking at the secondary market is that it’s a place (not physical) in which buyers and sellers can “meet” to transact in an ETF’s underlying securities without presenting significant disruption to the fund. Add to that, the additional activity usually isn’t a harbinger of inflows or, more importantly, outflows.

“Notably, this additive liquidity does not result from low fund flows. In fact, trading volumes from March 8-16 were significantly above average, soaring beyond $13 billion on March 13, as shown below. The only other time trading volumes were this elevated was during the Great Financial Crisis (GFC), when volumes spiked to over $30 billion,” adds Bartolini.

ETFs Not Damaging Underlying Markets

A frequent though unfound criticism of ETFs is that they are the tail that wags the dog. Meaning the proliferation of passive investments, particularly in the exchange traded wrapper, is altering the broader market landscape.

That’s not the case because, particularly in the case of equity and fixed income ETFs, it is those funds’ held securities that determine price action. Looked at another way, the aforementioned KRE and XLF aren’t making things worse on vulnerable bank stocks.

“As a result, the total percentage of trading in financial sector stocks likely to be specific financial sector ETF-related actions in the primary market was 1.7% from March 14-16. And as shown below, this percentage never broke above 4%, even on the day when total absolute flows were over $1 billion,” concludes Bartolini.

The Point: ETFs aren’t immune from broad market declines or sector-specific woes, such as a banking prices, but these instruments provide advisors tools for all-important liquidity and price discovery – factors that should not be overlooked.

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