Heightened volatility has been a theme in markets over the last few years. While a natural rise of volatility is often expected in the later stages of the cycle- especially when coming from the ultra-low levels of volatility we experienced for much of this economic cycle- are there other factors at play exacerbating volatility?  

It is at this point that many market participants are quick to point to the use of ETFs and the rise of that type of investment vehicles as a culprit of heighted volatility. But you might be surprised to know that ETFs actually dampen volatility and don’t cause it. The reason? The majority of ETF trading happens in the secondary market where shares of ETFs move directly between the hands of buyers and sellers. Only a small percent of the time, 11% as seen in the chart below, does that buy or sell order for an ETF vehicle need to dip a layer below into the primary market and be exchanged (created or redeemed) with the actual stocks or bonds that make up the basket. In fact, this dynamic of significantly more action in the secondary market than in the primary market is what provides additional liquidity to the market in the ETF space.

The poster child of supposed ETF volatility has been the high yield space as we show below. Yet, in the most recent period of volatility, December 2018, High Yield ETFs averaged about $3B/day in secondary activity (on exchanges) and only $500 million in primary activity dipping into the underlying bonds. This difference shows the additional liquidity that provides a buffer on the exchange.

While we can point to the barrage of geopolitical events that have shook markets (Brexit, the U.S. government shutdown) along with somewhat newer and problematic themes hitting markets (rising tech regulation, falling margins etc.) it’s easy to see why volatility would be up. The common misconception is that ETFs cause volatility, while in fact ETFs do just the opposite and dampen volatility.

High yield ETF volume spikes during times of market stress

% of overall high yield trading volume, 30-day rolling average

IncludedImage

Source: 2018 ICI Fact Book, Bloomberg, J.P. Morgan Asset Management. ETF high yield space represented by HYG, JNK, and PHB represents approximately 90% of trading activity. Data are as of 12/31/18.