Market Extra: Would ETFs hold up in an 1987-style crash?

The stock market of 2017 is very different than the market of 1987, when a historic one-day collapse occurred. One of the biggest changes is the now-ubiquitous presence of ETFs.

The rapid growth of exchange-traded funds, which trade like stocks and offer exposure to basically every investible asset class, including major bond categories, commodities, and precious metals, has raised the question of how they might perform and what impact they might have during an intense crash like the one on Oct. 19, 1987 that wiped out 23% in market value in a single day.

Read: 30 years after Black Monday, could stock market crash again?

Since the first ETF was launched in 1993, they have ballooned into a crucial part of the market, with nearly $4.2 trillion in global assets, according to research firm ETFGI. Credit Suisse data show that ETFs accounted for 30% of all U.S. trading in terms of value over 2016, as well as 23% of share volume. Based on both trading volume and value traded, 14 of the top 15 securities last year were ETFs.

Read: Here’s how much ETFs are dominating on the trading floor

Equity funds are especially popular, particularly the ones that passively track indexes like the S&P 500

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 or the Russell 2000

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which hold the same stocks as those indexes, and in the same proportion. According to FactSet, there is more than $2.5 trillion held in U.S.-listed equity funds alone, and one-seventh of all ETF assets are in funds that track the S&P.

The issue of whether ETFs might hurt market activity in the event comes as stocks are trading at their loftiest valuations in history by some measures, with at least some of those records levels and a march to all-time highs by equity benchmarks linked to exchange-traded product.

However, evaluating the potential influence of ETFs on Wall Street now requires an exploration of two key questions: first, would ETFs function as they’re supposed to in a massive drop, properly reflecting the price of their underlying holdings? Secondly, could their popularity exacerbate a market decline if investors were to sell them en masse, theoretically putting additional pressure on their individual components?

The urgency of the first question was underlined in August 2015, when a session with a historic amount of market volatility caused a number of ETFs to break down. The share price of a number funds fell more than the assets that comprise them because market makers—who take on risk to facilitate buy and sell orders—couldn’t accurately set fair prices for stocks. (The issue was concentrated within stock funds; fixed-income products weren’t as affected.)

Exchanges bore the brunt of the blame for these issues, and in response the largest U.S. exchanges—including Bats Global Market, Nasdaq, and NYSE Arca—announced joint efforts to improve trading in volatile markets.

Read about the reforms here

Several of the reforms have since been implemented, while others are slated to go into effect later this year. Additional changes have also been discussed, with some recommendations sent to the Securities and Exchange Commission earlier this year.

While the market hasn’t experienced a session with the same degree of selling as that late-August period two years ago, other volatile events, including the 2016 U.S. election and the U.K.’s vote to leave the European Union, have occurred without similar problems.

“In terms of what happened on August 2015, the specific issues that impacted ETFs have been pretty appropriately dealt with,” said Joel Dickson, global head of investment research and development at Vanguard. “There’s always going to be the question of what’s the next issue that could cause problems, but given the reforms, if that same environment were to occur again, the ETFs should reflect the underlying values of their securities, plus or minus a liquidity premium.”

Liquidity, or the ability to easily buy and sell securities without having a major effect on their price, is both a major factor behind the 1987 crash, when it dried up, and a major selling point of ETFs in general. The SPDR S&P 500 ETF Trust

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the oldest and largest ETF, is also one of the most liquid securities on any given day, with tens of millions of shares exchanging hands.

Liquidity buffer

So intertwined are these issues that one can even trace the invention of ETFs to the 1987 crash. The SEC, in a postmortem of the collapse, advocated for a single security that could represent the broad market, on the theory that such an issue could increase overall market liquidity. (One could buy a futures contract on the index, but those traded on the futures market and were regulated by the Commodity Futures Trading Commission.)

ETF price moves are determined by the moves of its underlying holdings, and assuring they move in tandem is the job of authorized participants (typically large institutions), who are able to arbitrage away any deviations between the price and the net asset value. If a day of heavy selling means than an ETF falls more than its underlying components, an authorized participant can profit off that difference.

Balchunas estimated that on days with heavy selling pressure, ETFs comprise 40% of total trading volume.

“Nothing can stop a bad selloff, but it is possible that the selling [in 1987] was exacerbated by a factor that could’ve been alleviated by the ability to sell the whole basket in one security,” said Eric Balchunas, ETF analyst for Bloomberg Intelligence. “If the basket traded at a discount, it would have gotten bid from an arbitrager,” which would’ve offset some of the selling pressure.

Balchunas estimated that on days with heavy selling pressure, ETFs comprise 40% of total trading volume. However, only 10% to 20% of ETF trading on those days actually involves the underlying securities, as opposed to simply exchanging shares of the fund.

“I can’t say the market would’ve sold off 16% instead of 22% had ETFs been around in 1987, but people smarter than me at the SEC looked at what happened and decided that having a liquidity buffer would help the market,” he said.

‘I can’t say the market would’ve sold off 16% instead of 22% had ETFs been around in 1987, but people smarter than me at the SEC looked at what happened and decided that having a liquidity buffer would help the market,.’

Eric Balchunas, ETF analyst for Bloomberg Intelligence

This speaks to the second issue, of whether ETF trading can have an impact on overall market moves. This has been hotly debated for years, particularly within the context of the active versus passive investing debate. The concern is, because investors essentially buy every stock in an index when they buy a passive fund, if a crash were to result in heavy selling of index funds, the entire basket would be sold regardless of the fundamentals of the individual underlying securities. And because ETFs are a way to make immediate decisions on the overall market (in contrast to mutual funds, which only price and trade at the end of day), selling them could mean the rout becomes more indiscriminate in what is being sold.

Such a thesis has never really been tested. Passive mutual funds were a negligible part of the overall market in 1987, and it would be several years before the first ETF surfaced. While they always had their current structure, ETFs were a fraction of their current size in subsequent selloffs, like the bursting of the dot-com bubble and the financial crisis. Compared with the nearly $3 trillion currently held in U.S.-listed ETFs, they had less than $500 billion at the end of 2008, according to ETFGI data.

Even at their current size, however, it can be easy to overstate their influence. While ETF adoption has never been higher, stock correlations have been falling, meaning movements in individual securities aren’t being dictated by the buying and selling of index funds. And even at their current size, they remain a small part of the overall market. According to UBS data, passive funds—including ETFs and mutual funds—only comprise 8% of the overall global equity-market value.

“If there is a ‘rush to the exit’ an ETF will likely trade to a discount that’s influenced by the volatility and the liquidity of the underlying market,” the Swiss bank wrote in September. However, “despite the growth in ETF assets, we believe the ETF market is better equipped to handle turbulent markets now than in the past.” UBS said funds had been “battle-tested,” and added that the ETF investor base is more diverse than it had been in the past, “as there has been greater adoption among both retail and institutional investors. This means there’s likely to be different investment views, objectives, and time horizons among investors, which helps to balance supply and demand.”

‘If there is a ‘rush to the exit’ an ETF will likely trade to a discount that’s influenced by the volatility and the liquidity of the underlying market.’

—UBS strategists

Still, passive investing—as opposed to active management, where the portfolio components are individually selected by managers—has undeniably had an impact on the market. According to Goldman Sachs, passive funds own an average of 17% of each component of the S&P 500. The investment bank also calculated that for the average component, the share of its stock that might trade on fundamental views has dropped to 77% compared with 95% a decade ago.

“The impact on portfolio construction, alpha and trading are not fully appreciated by investors,” the firm wrote in a note.

However, because a selloff of 1987’s magnitude would surely mean broad-based selling by institutions, portfolio managers, hedge funds, and retail investors, it is likely that ETFs would simply be tracking the decline, not leading it.

David Lafferty, chief market strategist at Natixis Global Asset Management, said he has heard predictions that ETFs would exacerbate a decline, as well as the opposite.

“I usually hear they will from active managers, who are upset they’re losing money to passive, or it’s the big ETF sponsors telling me it won’t happen. I suspect the truth is somewhere in the middle,” he said.

“Frankly, a lot of the money that has gone into passive funds would’ve gone into a lot of the same securities anyway, just in a different vehicle. If the S&P 500 suddenly drops by a third, we’ll never know if it would’ve gone down to the same extent if ETFs weren’t around. However, it seems naive to think they wouldn’t have some impact.”