A reliable bridge
Fast forward to the extreme market volatility resulting from the COVID-19 outbreak in March 2020: The ETF offered — and continues to offer — several benefits.
“SPY acted as a bridge between derivatives and cash … and that bridge is an important shock absorber in a period of uncertainty and high volatility,” Ireland said. For instance, futures faced intense selling pressure which constrained liquidity and influenced pricing mechanics. In addition, many underlying stocks were subject to Regulation SHO, which regulates short-selling and constrained portfolio hedging activity. “SPY acted as a conduit to both of those markets and [it has] allowed dealers to manage risk and buy-side participants to access liquidity in otherwise constrained markets,” he said.
SPY is also a reliable price gauge for institutional investors during periods of market stress, such as during the March 2020 volatility spike. “In a lot of ways, SPY formed a level of price discovery because, as markets were constrained, SPY was trading I wouldn’t say as is typical, but in an orderly way.… It provides a valve to the market where buyers and sellers can meet on exchange, [and] risk can be transferred without impacting the underlying securities.”
Numbers reflect user diversity
“Despite the fact that there are over 2,500 ETFs in the industry, over the last year SPY has represented over 24% of all ETF trading. It represented 20% of all listed ETF options contracts and about half of all listed ETF options contracts when adjusted to reflect notional exposure. And it represented over 26% of all exchange-reported notional short interest,” said Ireland. “So the product is used by a variety of different users. It is not just a buy-and-hold security, though there certainly is an element of buy and hold in the user base. There is also a significant base of tactical users; there are the hedgers; and then there are the more sophisticated institutional investors.”2
“As all those different parties meet on the exchange, they form this incredibly deep pool of liquidity. And ultimately, as the markets experience volatility, the depth of the user base has kept SPY spreads very tight, whereas other S&P 500 ETFs typically see their bid-ask spread widen, which reflects the risks associated with [their] underlying stocks,” added Ireland, noting that investors in SPY can more effectively navigate the liquidity constraints typically associated with higher market volatility.
He pointed to the strong parallel between market volume — which tends to spike during periods of market volatility — and the CBOE Volatility index, or VIX, a measure of the 30-day expected volatility of the U.S. stock market. Market participants tend to gravitate toward the most liquid proxy, “so the potential benefits [of SPY] become more evident when you need them the most.”
Consider total cost of ownership
Other considerations for institutional investors include overall transaction costs and execution speed. Since an ETF investor is responsible for controlling the transaction cost — as opposed to the mutual fund portfolio manager who transacts for the end investor — the total cost of ownership for an ETF like SPY should account for its unique liquidity profile.
“Your total cost-of-ownership consideration extends much further beyond the expense ratio when you factor in investment objective,” Ireland said. “With the significantly higher volumes and tighter spread, there’s improved transaction cost, and your market impact is significantly lower on a relative basis [compared with S&P 500 ETF] products that don’t have this derivatives ecosystem.”
“In addition — and this is something that was very relevant in March of last year — there is a much faster speed of execution,” said Ireland. “The risk associated with your order, over a period of time, is much lower because you are able to fill that execution faster.”
“Ultimately, the expense ratio of SPY [9.45 basis points] becomes less of a factor for investors seeking access to the the deepest pool of liquidity in U.S. equity markets.”
Read More: SPY Can Offer Enhanced Liquidity and Flexibility for All Users