At the close Monday (February 5th), volumes on all exchanges in the US had surged to $630bn versus an average of $280bn. This number was familiar; its almost identical to the $631bn that traded on August 24th 2015.Volatilitytoo had a similar ring to it, closing at 37.32 in Tuesday trading versus 40.74 on Aug 24th 2015 (Source: Bloomberg and Factset as of 2/6/18).
You may remember the date in 2015 because Asias and Europes markets had sold-off sharply and resulted inS&P 500 Indexfutures being limit down on the US open. This caused a delay in the open of various US stocks which in turn disrupted the opening and pricing of someETFs. There are numerous papers written on this subject so I wont rehash them here. I will, however, contrast with Monday (February 5th) trading.
Similarities… and Differences
In short, there were 300 ETFs (andETNs) that experienced 800 trading halts that August day. Today there were only 5 halts in 4ETPs(Exchange-Traded Products) and these were all strategies that track volatility. Given their underlying markets moved over 100% today, this is fully to be expected.
Generally, ETFs did exactly what they were supposed to do. There was an orderly sell-off in the ETFs in line with their underlying markets. We did observe some widening of spreads around the steepest part of the sell-off notably around 3:15pm, but again these did not materially dislocate from underlying markets. The good news is that markets settled somewhat overnight and we did not have to test the system with an August 24th style limit down open in the US market (Source: Bloomberg, as of 2/6/18).
What About High Yield?
Given recent discussion around liquidity in fixed income ETFs, specifically High Yield, it is worth reviewing how they performed. As an asset class, high yield did not see the same degree of sell off as equities, so as an illustration this is not a thorough test.
However, it was interesting to note how the ETF moved with their underlying bonds and provided price discovery. The largest high yield ETF traded 170% of its average daily volume and traded, as did the other major high yield funds, toward and then through the bid price of the underlying bonds (Source: Bloomberg, as of 2/6/18). When this happens, it is easy for commentators to suggest the ETF is trading at discount. However, we understand this to be price discovery as the ETF represents traded prices in the basket of bonds. This is proven this morning where the bond bids have moved down in line with where ETFs were trading yesterday. A smaller test for high yield ETFs, but another proof point for the ETF wrapper overall.
Volatility ETF Difficulties?
Now, there were a handful of ETPs that experienced difficulties. The 4 ETPs that experienced trading halts were all volatility products, long or short (Source: Bloomberg, as of 2/6/18). And given the huge moves in volatility, this is actually what should have happened. The ETPs that offered short volatility exposures experienced drawdowns in line with the spike inVIX. However, it is important to note that these issues were not actually problems with the ETF wrapper, or ETN wrapper for that matter, but a characteristic of inverse or leveraged exposure.
Hedge funds, individuals or anyone else with ashortposition in an asset class, is exposed to a sharp move higher in that asset class or security. Securities can move 100% higher, which would mean 100% loss for the investor. When this happens, the investor or fund becomes highly leveraged because their capital is now zero, but they are still short the security. Some investor types may be OK with this leverage and hold the position, as risky as that may be. However, the ETF or ETN wrapper, as clearly stated in their offering documents and prospectus, have a duty to return that leverage to 1, or whatever the stated leverage factor is.
Different products do this on different time frames, but in most cases this is daily. As such, the short products in question had to close most of their short positions in order to bring leverage back to 1x short. As I write, those short products are halted for trading until the outcome of Mondays move is measured in their products. Given a 1x short position and a market that moved between 80-115% higher, it is likely these products are permanently impaired (Source: Bloomberg, as of 2/6/18).
Key Takeaways
Overall, US ETFs were robust in Mondays sell off and today continue to trade freely the following day with the exceptions we mentioned. For context, ETFs traded $249bn Monday versus a 20 day average of $73bn (excluding Mondays huge volume). The most heavily traded ETF saw 4x its average daily volume with $79.6bn moving hands versus prior average of $18.5bn. There were also over 50 ETFs that traded more than 10x their ADV. This all suggests that ETFs made up around 39% of equity trading versus the 26% on an average day. ETFs did their job and gave investors liquid access to the global markets (Source: Bloomberg and Factset as of 2/6/18).
