I spent a good part of last week discussing the recent market volatility (how is that for an understatement?) and the role of ETFs during volatile times with various reporters. One very good financial reporter said something along the lines of “ETFs seem to have worked better this past week than they did during the Flash Crash.” He was of course referring to the events of May 6th, 2010, when the U.S. equity markets suddenly and mysteriously dropped nearly 1000 points before rebounding within 20 minutes, and implying that the large ETF market somehow contributed to the problems. My initial reaction to the comment was exasperation. It has been shown in multiple reports that market structure failures on several levels contributed to negatively impacting many listed products, not just ETFs. Apparently no amount of “mythbusting” will put this story to rest – I’ve addressed the issue with numerous reporters, as well as on our own blog here and here.

But then I thought, so be it. The thing is, every time this subject rears its head, I have more examples in my back pocket of how off-base the theory is. The past few weeks were no exception – here again we found ourselves in an extremely volatile market, and I’m hearing the rumblings of fear from investors about how ETFs might react, even that they might be the cause of the volatility. But the truth is, it’s in volatile markets that the benefits of ETFs can become the most apparent.  Let’s take a look at a few of those benefits:

ETFs can provide liquid access to a comprehensive breadth of products

We’ve seen it before and we’re seeing it again now – during volatile times, investors have increasingly turned to ETFs to express their views.  Exchange traded product (ETP) volume typically makes up almost 1/3^rd of US secondary market trading, but jumped to as much as 40% of total equity volume several days during the last week.  This increase from the historical average highlights one of the key benefits of ETFs – the enormous breadth of product available, which gives investors choice and access to a multitude of asset classes, sectors, countries, and more.  Specifically, during the past week we’ve seen a broad shift in iShares assets from domestic and international equity into fixed income, reflecting the flight to perceived “safety” that typically comes with uncertain times. 

ETF price discovery can provide investors with actionable prices

Ah, one of my favorite subjects (seriously, it’s only been a few days since I last waxed poetic about this).  Price discovery refers to the idea that ETFs can offer access to securities that trade on markets that are closed (as in the case of international funds) or less than transparent (the fixed income over-the-counter market).  With the most recent crisis being of the global variety, this has been an important characteristic.  Check out the chart below to see how 3 different ETFs tracking the S&P 500 Index (listed in London, Singapore and the US) allowed for nearly round-the-clock pricing information on US equities during a recent timeframe.  What does that mean?  It means that investors across the globe have the ability to express views on a particular aspect of the market no matter where they reside – and whether underlying markets are open or not.

Source: Bloomberg as of 8/10/11.  Past performance does not guarantee future results.

ETFs can provide investors with efficient trading opportunities

Throughout the mess of the past two weeks, with the average daily volume (ADV) on many iShares ETFs increasing substantially, bid-ask spreads remained stable for the vast majority of our funds.  In fact, out of our more than 220 ETFs, only 3 experienced minimal increases in spreads (reflecting the higher risk being priced in by market makers).  And many of our funds saw significant two-way volume, further illustrating the fact that investors have been turning to these vehicles as a way to express investment views in turbulent markets. 

I guess the upshot is that I’m happy to continue answering the question of how ETFs have performed in volatile markets, because the answer has always been pretty consistent.  In fact, given the recent durability of ETFs in this type of environment, I would expect we’ll be adding more adopters as a result, just as we have in the past.  One silver lining in an otherwise crazy time.

Source: Bloomberg

Shares of ETFs may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from an ETF by Authorized Participants, in very large creation/redemption units.

Although market makers will generally take advantage of differences between the NAV and the trading price of shares of an ETF through arbitrage opportunities, there is no guarantee that they will do so. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Bonds and bond funds will decrease in value as interest rates rise.