Another finding was the construction process for ETFs focuses on the most liquid segments of an asset class, meaning the index will be subject to rules – perhaps excluding some very illiquid securities – that improve liquidity. Furthermore, in replicating the index, the manager might optimise portfolio construction to further improve liquidity.
But that is all theoretical. What happens in the real world? Looking at some real-life scenarios, notably the December 2015 US short-term high-yield credit crunch, to analyse what happened to the relevant market ETFs during these periods reveals a number of things.
The evidence so far is that ETFs tracking less-liquid market segments, such as high-yield bond markets, in the main have helped to enhance market liquidity, with a substantial amount of trading done on a two-way basis in the secondary market alone. Although this does not increase liquidity of the underlying market, the additional liquidity available is beneficial to market participants.
It is fair to say that the emergence of ETFs on less-liquid underlying markets is a useful tool for investors seeking those exposures, and this is especially true for fixed income, where the development of this ETF market is part of the solution to meeting investor demand for underlying exposures.
Vincent Denoiseux is head of ETF quantitative strategy at Deutsche Asset Management
