In a compelling analysis published by Nasdaq.com, James Allen, head of Capital Markets Policy at CFA Institute, revisits one of the most urgent financial stability questions that emerged during the COVID-era market crisis: Are ETFs functioning as a stabilizing force, or are they driving the extreme volatility we’ve seen?
While ETF defenders cite liquidity and trading efficiency — BlackRock noted that ETFs made up 38% of U.S. equity trading during the last week of February 2020 — Allen warns that ETFs may no longer be mere “passengers” in the market. Instead, they might be “drivers,” capable of amplifying price swings and contributing to tighter correlations across asset classes.
“That historic extremes have been reached suggests the possibility that innovations such as exchange-traded funds (ETFs) exacerbated, if not led, the wild gyrations,” Allen writes.
This issue has major implications for policymakers and regulators. The Fed’s decision to purchase ETFs during the crisis — mirroring strategies used in Japan — was seen by some as an implicit acknowledgment that these instruments are now critical to market structure. But it also raises concerns that the underlying arbitrage mechanisms can break down, especially when ETFs hold opaque, illiquid, or leveraged assets.
“ETFs tracking weaker, illiquid, and leveraged instruments, including even high-quality bonds, were trading at wide discounts to the net asset value of their underlying holdings,” Allen points out, citing data from The Financial Times.
The article poses an unsettling question: Do ETFs reflect the value of their underlying holdings, or do they now determine those values?
The answer isn’t yet clear — and may take years of academic research to fully understand. But in the meantime, Allen calls for greater transparency in how ETF net asset values are reported, especially during market stress. It’s a prudent step to safeguard against systemic risks in an increasingly ETF-dominated market.