1

From: Subcommittee on ETFs and Bond Funds 

To: FIMSAC 

Date: April 10, 2019

Re: Report on the Design of Exchange-Traded Funds and Bond Funds – Implications 

for Fund Investors and Underlying Security Markets Under Stressful Conditions

The Subcommittee on ETFs and Bond Funds (“the subcommittee”) was tasked by FIMSAC to 

study the implications of the growth in fixed income exchange-traded funds (ETFs) and mutual 

funds on the liquidity and pricing in the corporate and municipal bond markets. In particular:

“The subcommittee is charged with assessing the consequences of the increased presence of 

fixed income mutual funds and ETFs in these markets, including their current and possible future 

impacts on the liquidity and pricing of the underlying bonds under a variety of scenarios, as well 

as investor understanding of these products. Topics that may be considered include the 

interaction of fixed income prices and fund prices, including through the ETF arbitrage process, 

an assessment of the impact of redemptions from funds in stressed conditions, an assessment of 

the potential impact of the rebalancing process on underlying markets, whether funds help to 

diversify sources of fixed income liquidity, the role of index providers, and retail investor 

education.”1

In the course of its fulfillment of this mandate, the Subcommittee on ETFs and Bond Funds has 

engaged in discussion with experts, including industry participants, academics, and (on some of 

these topics) regulators. The discussions have been both broad and technical, and a range of 

topics have been explored, some at length. The Subcommittee on ETFs and Bond Funds has 

previously written on related topics, including recommending establishment of a naming 

scheme for exchange-traded products (ETPs), 2 and recommendations to improve investor 

education surrounding ETPs as well as to explore the creation of a standardized centralized 

database to aggregate ETF information for the benefit numerous stakeholders. 3 This report –

which represents the views of the subcommittee and not those of FIMSAC or the SEC, its staff, 

or its commissioners – on bond funds in stressed markets represents the synopsis of certain 

aspects our research and fact-finding and is meant to also serve as a compendium of relevant 

research on the topic. 

 1 Fixed Income Market Structure Advisory Committee –Subcommittees, available at: 

https://www.sec.gov/spotlight/fixed-income-advisory-committee/fixed-income-market-structure-advisorycommittee-subcommittees.htm. 2 Recommendation for an Exchange-Traded Product Classification Scheme (Oct. 2018), available at: 

https://www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-etp-naming-conventionrecommendation.pdf. 3 Recommendations for Investor Education and Data on ETFs (Oct. 2018), available at: 

https://www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-etf-investor-education-and-datarecommendation.pdf.
2

It should be noted at the outset that questions pertaining to stressed markets, including 

systemic risk, are highly complex involving not only funds, but the underlying markets and the 

behavior of investors. Indeed, these topics have been extensively analyzed and discussed for 

many years. A full discussion of the history, debates, economics and academic treatment of 

any one of these topics would likely require a very lengthy and detailed report that lies beyond 

the scope of the subcommittee’s mandate. Rather, the subcommittee has chosen to focus on 

those topics that, in our view, have been the subject of the most discussion within the overall 

context of stressed markets and were similarly echoed in panel discussions.

4

 We emphasize 

that this report is not meant as a compendium of all the issues regarding stressed market 

behavior.

This report starts with a foundational education of mutual funds and ETFs and describes the 

growth in assets under management of bond funds and ETFs in recent years. Given the large 

amount of attention to ETFs in the press, we focus the next section on ETF liquidity and pricing, 

including the arbitrage mechanism and the role of Authorized Participants (APs). We then 

discuss SEC requirements regarding liquidity risk management. We present evidence on the 

effect of stressed markets on fund liquidity, pricing, investor flows, and the liquidity of 

underlying bondsthrough a discussion of recent liquidity stress episodes. This report ends with 

a roadmap for future research, focused on further exploring gaps in current learning, including 

questions surrounding potential limitations that similarly impact this report’s conclusions. 

 4 A complete record of the subcommittee’s meetings and panel discussionsis available at the SEC website at 

www.sec.gov.
3

Report on the Design of Exchange-Traded Funds and Bond Funds – Implications 

for Fund Investors and Underlying Security Markets Under Stressful Conditions

Important Disclaimer: This report represents the views of the FIMSAC Subcommittee on ETFs 

and Bond Funds. It does not represent the views of the SEC, its staff, or any of its 

commissioners.

1 Introduction

This report authored by the Subcommittee on ETFs and Bond Funds is to be submitted to 

FIMSAC as described in our attached cover letter. We begin our report with an overview of the 

structural characteristics of Exchange-Traded Funds (ETFs), mutual funds, and closed-end funds. 

These basic descriptions provide a foundation for further discussion relating the relationships 

between fixed income 5 ETF and mutual funds flows and the liquidity and pricing of the

underlying securities under various market conditions. Given the large amount of attention to 

ETFs in the press, we focus the next section on ETF liquidity and pricing, including the arbitrage 

mechanism and the role of Authorized Participants (APs). We review liquidity risk management 

strategies of managed funds, and summarize the behavior of ETF and bond fund investors in 

prior stressed markets, with an emphasis on the empirical evidence to date. We end our report 

with suggestions for future research, including questions surrounding potential limitations of 

our conclusions.

1.1 Structural Comparisons of Mutual Funds, Closed-End Funds and ETFs

A mutual fund is an investment company that pools money from shareholders and invests in a 

portfolio of securities. A mutual fund will issue new shares to fulfill investors’ purchase orders, 

and fulfill investors’ sell orders by redeeming its shares. The Investment Company Act of 1940 

requires that each business day a mutual fund calculate its NAV per share to reflect the current 

market value of the fund’s portfolio securities, based either on readily available market 

quotations or fair value determined in good faith by the fund’s board of directors. A fund’s 

share price is its NAV per share plus any applicable sales charge. Rule 22c-1 of the Investment 

Company Act requires that shareholders purchasing or redeeming shares receive the next 

computed share price following the fund’s receipt of the transaction order. 6

The time at which a mutual fund prices its shares can be found in the fund’s prospectus. Most 

funds price their shares at 4 p.m. EST. The SEC has stated that “Determining fair value requires 

taking into account market conditions existing at that time,” and that when choosing pricing 

vendors, “a fund’s board may want to assess, among other things, ... the extent to which the 

 5 Note that while some of our conclusions may extend to other asset classessuch as equity, it should be 

understood that our focus in this report is on fixed income funds. 6 Investment Company Institute, “Frequently Asked Questions About Mutual Fund Share Pricing”, 

https://www.ici.org/faqs/faq/mfs/faqs_navs
4

service determines its evaluated prices as close as possible to the time as of which the fund 

calculates its net asset value.” 7

Retail investorsrely on mutual funds to meet personal financial objectives, such as investing for 

retirement, saving for education, etc. Similar to fixed income ETFs, fixed income mutual funds 

provide individual investors a vehicle for diversification, such as tracking a broad index that

contains hundreds of constituent bonds, through a single purchase.

ETFs combine characteristics of both closed-end and mutual funds (Agapova 2011). Like a 

closed-end fund or a stock, ETF shares can be bought and sold intraday at market determined 

prices in the so-called secondary market. Unlike a mutual fund, this requires an investor to 

possess a brokerage account. Like a mutual fund, ETFs continuously offer their shares for sale. 

However, unlike mutual funds, ETFs do not sell or redeem individual shares; ETF shares are 

bought and sold directly from the ETF asset manager by specialized entities in blocks called 

“creation units.”

Exhibit 1 summarizes the differences among ETFs, open-end mutual funds, and closed-end 

funds across different dimensions. There are two key differences between how this process 

works in an ETF versus a mutual fund that are relevant for this report. First, in an ETF, end of 

day primary market trades (i.e., those resulting in a change in shares outstanding through the 

so-called creation/redemption mechanism) are facilitated only by APs, a pre-approved group of 

institutional firms who have entered into an agreement with the ETF’s distributor. The ETF 

creation and redemption mechanism allows the shares of the ETF to adjust to demand and 

supply. In open-end mutual funds, shareholders generally transact with the fund itself at the 

end of day and at net asset value (NAV), while in listed closed-end funds, investors sell on an 

exchange and receive cash based on market liquidity at that moment in time but the supply of 

shares is fixed. 

Second, in many ETFs, primary trades happen “in-kind” and do not require securities purchases 

or sales by the ETF.8

 To execute an in-kind trade, an AP presents a basket of securities to (or 

receives a basket of securities from) the ETF in exchange for ETF shares. 

 7 SEC Release No. 33-9616, “Money Market Fund Reform; Amendments to Form PF” 8 Rule 22e-4(a)(9) under the Investment Company Act of 1940 defines “In-Kind ETF” as “an ETF that meets 

redemptions through in-kind transfers of securities, positions, and assets other than a de minimis amount of cash 

and that publishes its portfolio holdings daily.” The SEC staff has stated that it would be reasonable for an In-Kind 

ETF to determine that if the percentage of its overall redemption proceeds paid in cash does not exceed 5%, such 

use would bedeminimis. TheSEC staff has alsostated thatif an ETF’s percentage of overall redemption proceeds 

paid in cash exceeds 10%, it would be unreasonable to consider it a deminimis amount of cash for purposes of 

qualifying as an In-Kind ETF. See Staff of the Division of Investment Management, “Investment Company Liquidity 

Risk Management Programs, Frequently Asked Questions (as of Feb. 2018), at Q11, available at: 

https://www.sec.gov/investment/investment-company-liquidity-risk-management-programs-faq. 
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Exhibit 1: 

Comparison of Fund Structures

Attribute Mutual Funds Closed-End 

Funds

ETFs

Trading End-of-day at NAV Intraday Intraday (for investors 

other than APs, who 

can also trade end-ofday at NAV)

Visibility into 

Holdings 

(Transparency)

Typically monthly or 

quarterly

Typically monthly or 

quarterly

Daily9

Shares 

outstanding

Number of shares can 

change at end of day 

based on purchases and 

redemptions

Supply of shares is 

fixed

Number of shares can 

change at end of day 

based on creations and 

redemptions

Pricing All transactions are at 

the fund’s end-of-day 

NAV

Initial public 

offering price

and after IPO - 

market determined

Primary market- endof-day NAV

Secondary marketmarket determined

Liquidity (investor 

perspective)

End of day only

(Primary Processes)

Intraday – subject 

to market liquidity 

(Secondary 

Market )

Intraday (Secondary 

Market) and End of day 

(Primary processes)

Redemption 

Issues

Cash – fund managers 

trade to meet net 

redemptions; there may 

be redemption fees

No redemption as 

shares are fixed; 

only secondary 

market trading

Primary market 

trading via APs adjusts 

shares

Settlement Cash Cash In-kind or cash

Source: Based on descriptions in Agapova (2011), ICI (2018), Madhavan (2016) and other 

sources.

 9 SEC exemptive orders for actively managed ETFs and recent orders for index-based ETFs with an affiliated index 

provider have required full portfolio transparency. Exemptive orders for index-based ETFs with an unaffiliated 

index provider have required publication of the ETF’s baskets. See Securities and Exchange Commission, 

“Exchange Traded Funds” (2018) at n. 207, available at:https://www.sec.gov/rules/proposed/2018/33-10515.pdf. 
6

1.2 Growth of Fixed Income Mutual Funds and ETFs

Assets in fixed income open-endmutual funds and ETFs have seen rapid growth in recent years. 

Overall, fixed income mutual funds and ETFs account for 11% of the U.S. bond market (US 

government bonds, corporate bonds, and tax-exempt bonds) as of December 2018, up from 7% 

a decade earlier. Fixed income index mutual funds (i.e., those that seek to track an index) held 

approximately 1.5% and actively managed mutual funds 7.8% of the $40.3 trillion US fixed 

income market, as of year-end 2018. The corresponding figures for ETFs (primarily index, but 

includes some active funds) is 1.6%. 10

The share of global assets under management in fixed income ETFs is rising, and at a faster rate 

than fixed income mutual funds. 11 Exhibit 2 below shows global fixed income, equity,

commodity and other types of ETF assets under management to illustrate the increase in fixed 

income ETF assets from when the first such fund was introduced in July 2002. 12

Exhibit 2: 

Global ETP Assets

Source: BlackRock ETP Landscape October 2018

 10 Retail investors (i.e., households) held 95% of US long-term mutual fund (equity funds plusfixed income funds) 

total net assets at year-end 2017. Investment Company Institute, Investment Company Fact Book (2018 and 2014 

annual editions) and “Trends in Mutual Fund Investing, December 2018” monthly release.

11 Investment Company Institute 2018; Hill, Hougan, and Nadig 2016. 12 Source: ETF.com October 2017 ETF Report, available at: https://www.etf.com/publications/etfr/issue/fixedincome

0

1,000

2,000

3,000

4,000

5,000

6,000

(US$bn)

Commodities & Others

Fixed Income

Equity
7

Fixed income ETFs have experienced growth in a variety of sub-asset classes of the bond market

in recent years. Initially, these were typically portfolios of investment grade and government 

bonds, but have been extended to other categories including high-yield bonds, emerging 

market bonds, and even bank loans. Exhibit 3 shows a snapshot of assets globally across a wide 

variety of sub-asset classes of fixed income ETFs as of October 2018. The graph is shown in 

dollar amounts but the relative sizes are immediately obvious.

Exhibit 3: 

Fixed Income ETP Assets by Category in Billions of Dollars

Source: BlackRock ETP Landscape October 2018

1.3 Factors the explain the growth in fixed income ETFs and Bond Funds

What factors drive the growth in open-end mutual fund assets and ETFs in particular? 

Investors in individual bonds face a number of challenges. First, many individual corporate 

bonds trade primarily in the opaque, dealer (“over-the-counter” or OTC) market characterized 

by a lack of accessible pre- and post-trade transparency, lack of liquidity, and infrequent

trading. Bid-ask spreads in fixed income markets can be significantly higher than spreads in 

equity markets, particularly for retail size transactions, and dealers may build their commissions 

(“mark ups”) into prices. By contrast, fixed income ETFs trade intraday on electronic exchanges 

59

140

106

49

38

62

170

 High Yield Corp Broad U.S. Treasury Sovereign

 Municipal Emerging Markets Debt Other Fixed Income
8

(“lit” markets) that offer a high degree of transparency, meaning that actionable bid and offer 

quotes are readily available. 

Second, many fixed income ETFs have low bid-ask spreads compared to the underlying bonds 

(Madhavan 2016), and commissions are explicitly stated, as with equities.

13 For individual 

investors, it may be easier and cheaper to invest broadly in fixed income through an ETF (and a

mutual fund) as opposed to purchasing individual bonds through their broker.

Third, from the viewpoint of portfolio construction, keeping constant the maturity of a fixed 

income portfolio comprised of individual bonds may require ongoing attention and frequent

trading, but a fixed income ETF (and a mutual fund) can be designed to do this without the 

need for trading. For individual investors, fixed income ETFs and broad, open-endmutual funds

provide a way to obtain instant diversification (many tracking indexes such as the iBoxx 

Investment Grade Index or the ICE BofAML 0-5 Year US High Yield Constrained Index with 

hundreds of constituent bonds) in a single trade. 

In the context of these challenges, fixed income ETFs, like mutual funds, are attractive to 

individual (retail) bond buyers because of low cost, diversification, and transparency. Other 

investor types, such as hedge funds or large institutions, increasingly use fixed income ETFs for 

a variety of purposes including gaining broad market exposure, as tools to mitigate risk in

portfolio transitions (where institutions move assets from legacy to target portfolios), and for

portfolio completion (e.g., filling in an exposure gap, say, with emerging market bonds to 

complement an exposure to broad global fixed income), etc.

14

In the context of the growth in fixed income index mutual funds and ETFs that track indexes, it 

is worth noting that the concept of index investing in fixed income is not as well established as 

in equities. Exhibit 4 shows the approximately $40 trillion US fixed income market broken 

down by investment category. We distinguish index and active mutual funds, and also estimate 

the assets tracking indexes that are managed by institutions. Note that the ETF figures include 

both index and active funds, but the great majority of ETF assets are in index products. We 

note that most US fixed income assets (74%) are not managed by asset managers including 

those held by individuals, insurance companies, official institutions, etc. The remainder are 

“managed” in the sense that active managers, index managers, hedge funds, and others 

manage these assets with the objective of either tracking or outperforming an index. The share 

of ETFs is about 1% of the assets in investment grade and 3% of high yield (Madhavan 2016).

15

 13 For example, in 2018, municipal bonds, high-yield bonds, and investment grade bonds typically traded at bid-ask 

spreads of 25, 50, and 35 basis points, respectively.13 By contrast, large fixed income funds (with assets of over 

$10 billion) typically traded at spreads around 1 basis point.(BlackRock, Bloomberg, Barclays, NYSE Arca, as of 

6/30/18.) 14 See, e.g., Greenwich Associates, “ETFs: U.S. Institutions’ New Tool of Choice for Portfolio Construction,” (2019) 

or Tabb Group (2019) surveys.

15 Dannhauser (2017) compares the corporate bond ETF trading volume with total TRACE volume in ETF bonds. In 

the last quarter of 2013, ETFs trade $2 for every $5 of the underlying bonds. Since then, secondary market ETF 

volume has increased in ratio.
9

These statistics are worth keeping in mind as we turn to the possible risk factors associated 

with fixed income mutual funds and ETFs in stressed markets.

Exhibit 4: 

Distribution of US Fixed Income Assets – By Investment Style

Source: “Index Investing Supports Vibrant Capital Markets”, BlackRock ViewPoint (2017), 

available at https://corpgov.law.harvard.edu/2017/10/23/index-investing-supports-vibrantcapital-markets/ Data from World Federation of Exchange Database (WFED), BIS (data as of Q3 

2016), HFR, Cerulli, Simfund (data as of Dec 2016), iShares GBI (data as of Dec 2016), Global 

Heat Map, McKinsey Cube.

1.4 Potential Impact of Mutual Funds and ETF Flows

1.4.1 Fixed Income Mutual Funds

Policymakers and observers have focused on flows into and out of fixed income mutual funds –

especially during periods of market stress – as a potential contributor to higher volatility and 

risk.

16 In this section, we review some of the major considerations around flows out of fixed 

income mutual funds and, in the following section, ETFs. The impact of flows, particularly in 

 

16 See for example:

Financial Stability Oversight Council, “Update on Review of Asset Management Products and Activities”, 

https://www.treasury.gov/initiatives/fsoc/news/Documents/FSOC%20Update%20on%20Review%20of%20Asset%

20Management%20Products%20and%20Activities.pdf

International Monetary Fund, “Plain Vanilla Investment Funds Can Pose Risks”,

https://www.imf.org/en/News/Articles/2015/09/28/04/53/sopol040815b

International Monetary Fund, “The Asset Management Industry And Financial Stability”, 

http://www.imf.org/external/pubs/ft/gfsr/2015/01/pdf/c3.pdf

Index Mutual 

Funds

1.0%

ETFs

0.9%

Institutional 

Indexing

1.8%

Internal 

Indexing

0.3%

Non 

Indexed

95.9%
10

times of market stress, is part of the subcommittee’s mandate to form an “assessment of the 

impact of redemptions from funds in stressed conditions, an assessment of the potential 

impact of the rebalancing process on underlying markets.” As noted previously, the subject of 

risk is complex and has been the subject of considerable previous academic and regulatory 

efforts. A detailed analysis requires context of other participants in the fixed income markets,

the investor base in these funds and how banks, broker-dealers and others would respond in 

similarly stressed market conditions, subjects that are beyond the scope of the present report. 

We do not address whether any of the predicted outcomes are better or worse, from a policy 

perspective, than counterfactual market compositions. Rather, we focus more on the evidence 

to date on flows from funds, and how fund structures, as discussed earlier, may be relevant. 

We had noted that a defining feature of mutual funds is their daily redeemability. Mutual fund 

shareholders may redeem their shares at the end of any business day. A fund must stand ready 

to meet any redemptions while also fulfilling ongoing obligations to its remaining shareholders, 

including the fund’s duty to pursue its stated investment objective, strategies, and policies. 

Reducing the risk that funds will be unable to meet redemption obligations and mitigating 

possible dilution of the interests of fund shareholders formed part of the SEC’s stated rationale 

for regulations addressing Open-End Fund Liquidity Risk Management Programs and related 

disclosure rules that were finalized between 2016 and 2018. These regulations are discussed 

below in Section 2.5 of this report.

Historical data on the behavior of both fixed-income fund investors and the funds themselves 

do not clearly support the idea that a prolonged decline in bond prices would drive fund 

shareholders to sell en masse. For example,fixed income mutual funds’ $144 billion cumulative 

net outflows between October 1, 2018 and January 9, 2019, a recent period of high volatility,

represented 3.4% of the $4.2 trillion in fixed income mutual funds as of September 2018 

(before the start of the outflows).Despite $32 billion of net outflows from fixed income mutual 

funds in October 2018, all major categories of fixed income funds were net buyers of bonds 

that month.17

Exhibit 5 below summarizes some of the relevant data on outflows as a fraction of assets under 

management. Prior periods of sustained outflows from fixed income funds in 2008, 2013, 2015, 

and 2016 likewise amounted to a small share of fixed income fund assets. The longest and 

largest such period, encompassing 31 weeks from June 5, 2013 to December 31, 2013, 

coincided with $168 billion in outflows, or 4.8 percent of fixed income fund assets at the time.18 

 17 Investment Company Institute, “Debunking Assumptions About Bond Mutual Funds’ Flows and Bond Sales”, 

https://www.ici.org/viewpoints/view_18_bond_flows_purchases, and “Summary: Estimated Long-Term Mutual 

Fund Flows Data (xls)”, https://www.ici.org/info/flows_data_2019.xls 18 Investment Company Institute, “Debunking Assumptions About Bond Mutual Funds’ Flows and Bond Sales”, 

https://www.ici.org/viewpoints/view_18_bond_flows_purchases
11

Exhibit 5: Redemptions from Fixed Income Mutual Funds as a Share of Fixed Income Fund Assets

Period of Net Redemptions Cumulative Outflow

($ billions)

Percentage of Total Net 

Assetsa

6/5/2013–12/31/2013b -$168 -4.8%

9/18/2008–12/17/2008 -$73 -4.2%

10/1/2018–1/9/2019 -$144 -3.4%

7/29/2015–10/7/2015 -$56 -1.6%

11/11/2015–2/13/2016 -$43 -1.2% a Cumulative outflow over the period as a percentage of fixed income mutual fund assets at the month-end prior to the start of the 

period of net redemptions.

b Data contain two one-week periods with small inflows.

Source: Investment Company Institute and ICE Data Services 

In summary, the evidence to date does not provide support for the notion of a negative 

feedback loop, where volatility drives net outflows that in turn cause portfolio managers to sell 

assets to meetredemptions, further accentuating a decline in the overall fixed income markets.

Having discussed the possible impacts of redemptions from fixed income mutual funds in times 

of stress, we turn now to the corresponding questions for fixed income ETFs. 

2 Liquidity of Fixed Income ETFs and Underlying Securities

The rapid growth of ETF assets, particularly in less liquid parts of the bond market such as high 

yield, has generated considerable discussion and several commentators have raised liquidity 

concerns.

19 We consider ETFs separately from mutual funds, and discuss certain characteristics 

particular to this vehicle including fixed income ETF liquidity and pricing, possible risks 

presented by the role of APs– including “step away” risk (where APs possibly simultaneously 

cease their primary market activities) and “liquidity mismatch” risk (where the fund’s 

underlying constituents are relatively illiquid). We also discuss effects of stressed market 

conditions on liquidity and pricing for ETFs and mutual funds. 

 19 As a recent example, see “Why Most Index Funds and ETFs Are Not Good Investments,” by Robert C. Lawton, 

Forbes, April 7, 2019, who notes: “There is concern from many investors about the liquidity of ETFs especially 

during significant market volatility. The more thinly traded the ETF, the more likely it will have pricing issues during 

periods of market stress. Also, those ETFs that tend to be uniquein their composition are thought to be subject to 

mis-pricing during periods of market volatility. With over 2,000 ETFs in existence, many feel at least half are subject 

to liquidity problems.” Available at: https://www.forbes.com/sites/robertlawton/2019/04/07/why-most-indexfunds-and-etfs-are-not-good-investments/#373182f17555
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2.1 Impact of Fixed Income ETFs on the Liquidity of the Underlying Markets

We begin with an examination of the possible impacts of the growth of fixed income ETFs on 

the liquidity of underlying bonds. Liquidity is a term commonly used to refer to the ability to 

buy or sell without significantly impacting the market price of the security. Some academic 

theories (see Bessembinder, Spatt and Venkataraman, 2018) suggest that the presence of an 

ETF could improve the liquidity of the underlying bonds in many ways. ETFs may provide a lowcost mechanism for fixed income dealers to hedge their inventory risk, and thus may reduce 

bid-ask spreads in the underlying bonds. The competition among participants performing ETF 

arbitrage could increase dealer participation and further attract new traders, thus leading to a 

liquidity spillover from ETF to the underlying bonds by arbitrage trading (Nam 2018). Evidence 

from equity markets suggests that increases in ETF ownership decrease the trading costs for 

institutional investors in the underlying stocks, and that the main mechanism is via a reduction 

in price impact costs due to an improvement in stock resiliency (Saglam, Tuzun and Wermers 

(2018)).

Further, the trading advantage of informed participants over less sophisticated traders is lower 

in a basket portfolio than in individual securities (Subrahmanyam 1991). This is because 

information asymmetries that arise due to security-specific private information are less severe 

in basket portfolios than individual securities. The growth in AUM of fixed income ETFs suggests

that these products offer a convenient way for fixed income investors to build diversified 

positions.

However, other studies point out that the migration of less-informed traders to basket 

securities, such as ETFs, could hurt the liquidity of individual securities that make up the basket 

(an early study is Gorton and Pennecchi 1993). Evidence from equity markets suggests that the 

introduction of a basket security, such as equity index futures or ETFs, is associated with a 

deterioration in liquidity of the underlying stocks (Jagadeesh and Subrahmanyam, 1993) and 

more recently Israeli, Lee and Sridharan (2017). In the context of corporate fixed income ETFs, 

Dannhauser (2017) finds that ETFs reduce the proportion of retail trading and increase 

institutional ownership in the underlying bonds, and insignificantly or negatively impact the 

liquidity of individual corporate bonds. By comparing liquidity of corporate bonds before and 

after introduction of ETFs, Nam (2018) finds that liquidity improvements are larger for highly 

arbitraged, low volume, high-yield, long-duration bonds, and for 144A bonds, indicating that 

bonds that are less accessible to investors before ETF introduction benefit from the liquidity 

spillover from ETFs. 

In summary, the theoretical and empirical evidence regarding the impact of fixed income ETF 

growth on the liquidity of the underlying bond markets is not conclusive, and is an area for 

future research. 

2.2 Understanding Fixed Income ETF Premiums and Discounts
13

One of the main sources of confusion with respect to fixed income ETFs is the observed 

premium (or discount) to NAV and the volatility of these premiums. Many commentators 

assume that deviations of price from NAV for fixed income ETFs represent pricing errors, 

particularly in times of market stress. Further, the size and volatility of premiums and discounts 

for fixed income ETFs appear to be much larger than corresponding equity ETFs (Tucker and 

Laipply 2013), leading to perceptions of relative inefficiency. Premiums and discounts in fixed 

income ETFs tend to widen in absolute value in more volatile times (Madhavan and Sobczyk 

2016; Antoniewicz and Heinrichs 2015). 

ETFs can be active or may track indexes. Common indexes – by design – typically contain more 

liquid bonds than the entire universe. Secondary market liquidity and low bid-ask spreads (for 

large funds) mean that fixed income ETFs are often the choice of exposure vehicle in times of 

stress. ETF prices equilibrate supply and demand, even in stressed times when the underlying 

bonds may be more illiquid. Indeed, while fixed income ETFs trade throughout the day on an 

exchange, many individual OTC bonds may not trade at all on a given day. So, larger absolute 

premiums and discounts to NAV in times of market stress are not evidence of mispricing; they 

are to be expected given the points above. 

Of course, some premiums/discounts do reflect transitory price shocks, but these should be 

arbitraged away quickly if they exceed transaction cost bounds, as explained below. Madhavan 

and Sobczyk (2016) examine statistically all US-domiciled ETFs in the period 2005-2014,

including equity and fixed income ETFs. They conclude that premium/discount volatility is 

mainly a reflection of infrequent trading of the underlying bonds as constituents in the OTC 

market, rather than anomalous behavior of the ETFs themselves. The difference in return 

behavior can lead to premiums/discounts to NAV that are independent of true dislocations in 

value. Staleness in prices and illiquidity means that NAV adjusts more slowly, causing 

premiums or discounts to widen, particularly in stressed times.

We also note that premiums and discounts in fixed income ETFs may reflect the over-thecounter nature of the bond market. Individual OTC fixed income securities typically trade at 

much wider bid-ask spreads than listed domestic equity securities (Hendershott and Madhavan 

2015).

20 The wide bid-ask spreads and relative lack of trading lead to larger arbitrage 

boundaries than typical equities; these spreads are reflected in market price deviations from 

NAV (note that fixed income ETF NAVs are typically marked to the bid side of the underlying 

market), relative to domestic equity ETFs. 

In summary, premiums and discounts for fixed income ETFs are not necessarily evidence of 

mispricing or of challenges to liquidity. Clearly, there is scope for more academic research on 

this subject including the link between primary market activity and actionable arbitrage 

opportunities. 

 20 Bessembinder, Spatt and Venkataraman (2018) present the academic evidence on trading activity and 

transaction costs in Treasury, corporate, municipal and structured credit markets. 
14

Another set of concerns voiced by commentators regarding ETFs in general (not solely fixed 

income funds) relates to the unique way that ETFs adjust their shares outstanding, a subject we 

now turn our attention towards.

2.3 Authorized Participants and “Step Away” Risks

2.3.1 Understanding the Arbitrage Mechanism

The key role of APs in adjusting the ETFs shares outstanding to reflect supply and demand has 

often given rise to questions about the possibility of market disruption should one fail or if they 

were to “step away” in unison during a time of heightened volatility.

Before we consider this potential, it is helpful to define the various participants in the 

ecosystem from a liquidity provision perspective. It is important to note that APs and market 

makers (i.e., broker-dealers who regularly provide two-sided (both buy and sell) quotations) are 

distinct. An AP does not have to be a market maker in a given ETF, nor does a market maker 

need to be an AP. That said, some institutions are both an AP and a market marker in a given 

ETF. As noted earlier, only APs have the ability to utilize the creation/redemption process 

explained earlier. 

Most active APs also act as agents to facilitate creations or redemptions (known as primary 

market trading) on behalf of their clients. 21 These activities could be on behalf of market 

makers, as well as institutions trading in large blocks who find it cheaper to (say) buy an ETF via 

the channel of primary market liquidity than trading in the secondary market. In this respect, 

the AP can be viewed a provider of technology that facilitates the creation and redemption 

process. Market participants (APs and market makers) use this technology (or capability) to 

balance the supply and demand of the ETF shares.

APs play a critically important role (see Antoniewicz and Heinrichs (2015) and Pan and Wang 

(2018)) through the creation/redemption arbitrage mechanism. Exhibit 6 below shows the 

normal arbitrage process where the AP reacts to a discrepancy between the price of a fixed 

income ETF and intrinsic value (i.e., the current value of the underlying basket) of the funds, 

resulting in a creation or redemption. In the top panel, the ask price of the ETF in the 

secondary market has fallen to $85 (the bid price will be lower) while the average price of the 

underlyingbasketof bonds inclusive of transaction costs (i.e., the average bid price) is assumed 

to be $90. (Note that in this illustrative example, the price of the bond basket is not necessarily 

NAV because this value may be stale and may not reflective of where the basket presently 

trades.) The AP (or a market maker utilizing them) sells short the bond basket while 

simultaneously buying the ETF, locking in a $5 gain per share (less creation/redemption fees) at 

the time of the trade. The position is closed out from an accounting perspective at the end of 

 21 APs do not receive compensation from the ETF sponsor and have no legal obligation to create or redeem the 

ETF’s shares. Rather, APs are compensated either through their market making activities in the secondary market, 

or through service fees they collect from clients (such as independent market makers) who may engage them to 

facilitate primary markettrades on their behalf. 
15

the day when the AP redeems the ETF to obtain the bonds needed to cover the short position. 

The bottom panel shows the reverse. 
16

Exhibit 6:

Fixed Income ETF Arbitrage Illustrative Example (ETF Price below Intrinsic Value)

Market Intraday 4:00pm NAV

Open Trading Same Day

• Buy fixed 

income ETF 

shares at ask

price of $85

• ETF Redemption

–Deliverfixed 

income ETF 

shares to issuer

• Receive 

underlying bond 

basket

• Covershort 

position for $5 

profit per share

(less fees)

• Sellshort

underlying 

bond basket 

average bid

price of $90

ETF Arbitrage Illustrative Example (ETF Price above Intrinsic Value)

Market Intraday 4:00pm NAV

Open Trading Same Day

• Sell short

fixed income

ETF shares at 

bid price of 

$95

• Deliver

underlying fixed 

income basket 

• Receive ETF 

shares (creation)

• Profit $5 per 

share (less fees)

• Buy 

underlying 

bond basket 

at ask for $90

Note: Hypothetical example for illustrative purposes only. Although market makers will 

generally take advantage of differences between the NAV and the trading price of ETFs shares 

through arbitrage opportunities, there is no guarantee that they will do so.
17

Observe that primary market flows are in the same direction of the difference between price 

and the intrinsic value of the basket, net of transaction costs. The process depicted in Exhibit 6 

represents what is typically referred to as the arbitrage process in the primary market. In the 

secondary market, any trader (including hedge funds, market makers, and others) may choose 

to buy or sell ETFs if they believe they can profit from the trade. Such actions also will tend to 

align the ETF price with the perceived intrinsic value of the fund.

2.3.2 “Step Away” Risks

One of the concerns often voiced around APs has to do with the possibility that they cease their 

arbitrage activities in times of stress, possibly at the same time, causing a price dislocation. 

Before we review so-called “step away” risk, it is useful to provide some context on the number 

of ETF APs. An analysis of 931 US ETFs by Antoniewicz and Heinrichs (2015) covering $1.8 

trillion of assets under management shows that the largest ETFs – presumably those funds of 

most concern from a systemic risk perspective – have an average of 38 APs.

22 

Exhibit 7 shows the mean number of APs across equity and fixed income ETF categories. In the 

event an AP steps away from the market, other active or inactive APs may act upon the 

opportunity to interact with the ETF, although there is no obligation to do so. Liquidity 

providers such as market makers or hedge funds may also buy an ETF share that is trading at a 

price that is below its intrinsic value on the secondary market if their profit exceeds transaction 

costs.

 22 The new Form N-CEN contains informationthat will shed more light on APs.
18

Exhibit 7:

Mean Number of APs by ETF Category

Source: Antoniewicz and Heinrichs (2015,) based on ICI survey data.

Still, the fact that there are multiple APs for fixed income ETFs does not necessarily imply that 

“step away” risk is not a concern. Even though corporate bond ETFs typically have an average 

of 25 to 35 APs, only a handful of APs create or redeem shares actively on a typical trading day 

(Pan and Zeng 2018). Evidence from equity markets indicates that market makers without 

affirmative obligations tend to withdraw participation in unison when market conditions are 

stressful (Anand and Venkataraman 2016). APs are not required to create or redeem ETF 

shares. What could happen if all APs were to simultaneously withdraw in a major market 

event? In this scenario, with no link to adjust the ETF’s shares outstanding, the ETF would likely 

trade like a closed-end fund (that is, a fund with a fixed number of shares) with possibly wider 

premiums or discounts until at least one AP were to resume their operations. 

We note that even in the Great Financial Crisis of 2007/8 and in other bond market stress 

events subsequently, there was not a case when APs all ceased their operations. A final nuance 

worth noting is the earlier highlighted distinction between APs and market makers. Presumably 

if actionable discounts were sufficiently large, market makers would buy ETF shares that were 

trading well below intrinsic value, stabilizing prices. As we have discussed, the AP’s 

“technology” or capability to create/redeem shares can be utilized at a modest creation cost by 

other participants such as market makers or liquidity providers (e.g., hedge funds), meaning 

that even if they choose not to deploy their capital there is still a mechanism to adjust shares 

outstanding. 

0 5 10 15 20 25 30 35 40

All

Domestic Equity

International Equity

Emerging Markets Equity

Domestic High-Yield Bond

Emerging Markets Bond
19

2.4 Liquidity Mismatch

In the case of ETFs, liquidity concerns have been raised in the context of intraday trading of

ETFs whose underlying constituents are relatively illiquid, so-called “liquidity mismatch.” These 

concerns arise in both the primary or secondary markets.23

Liquidity in the primary market, where the underlying securities trade, refers to the ability of 

APs to acquire the underlying assets and transfer them in-kind to the ETF provider for shares in 

the fund or vice versa. As noted above, creations and redemptions by APs act to correct price 

deviations between the ETF and underlying basket. However, Pan and Zeng (2018) suggest that

APs may exacerbate a price decline in an ETF by “wrong way” trading, particularly in less liquid 

market segments. In their argument, APs may not efficiently facilitate the arbitrage process 

under certain circumstances when the individual securities are hard-to-trade – that is, when the 

magnitude of an AP’s bond inventory positions is large, thus leading to limited risk bearing 

capability, or when market conditions are stressful such as periods with high volatility, low 

liquidity, and high short selling costs, which make arbitrage more difficult. 

Given their dual role as bond market makers and ETF arbitragers, Pan and Zeng (2018) argue

APs may strategically use the ETF creation/redemption process to manage their inventory risk, 

and these conflicted incentives could further destabilize the market. So, in the case where the 

ETF price is below the intrinsic value of the basket (Panel A of Exhibit 6) that the AP would 

create more shares (as opposed to redeeming) by delivering up individual bondsto reduce their 

inventory carrying costs. If the AP were to sell these newly created shares, this could push the 

price of the ETF down further relative to the basket. But this behavior implies from Exhibit 6 

above that the AP is forgoing profit from arbitrage. Further, other participants, such as market 

makers, may utilize the AP technology or capability to create or redeem as we noted earlier. 

Another set of concerns relate to the so-called secondary markets, the venues where ETF 

shares trade. As previously noted, the trading of ETF shares on exchanges in the secondary 

market does not directly drive buying and selling of the underlying bonds but rather reflects 

changes of ownership of the ETF. Purchases and sales of stocks driven by the ETF creation and 

redemption process account for 3% of all US equity market trading.24 In that sense, the ETF 

liquidity in the secondary market (via the creation/redemption mechanism of arbitrage) is 

generally greater than or equal to the liquidity of the underlying assets, and can add a layer of 

incremental liquidity to the financial markets. From a financial stability viewpoint, this buffer is 

additive. 

 23 While commentators often note that share volumes in ETFs have been rising as a fraction of average daily dollar 

volume it should be noted that these transactions are really exchanges of ownership in the ETF (buyers and sellers 

meeting on the exchange), not actually transactions with the ETF. 24 Source: Citi ETF Perspectives, by Scott Chronert, March 12, 2019.
20

Further investigation is warranted to understand how APs participate under normal and 

stressful environments, and whether their participation tends to become highly correlated 

under stress conditions, which might point to a fragility scenario that warrants design 

improvement. There is also a need to understand the determinants of entry and exit by APs 

and how these entities compete with other liquidity providers such as market makers.

2.5 Liquidity Reporting

Another frequent topic that arises in the context of funds operating in stressed markets is their 

liquidity profile. The SEC recently adopted new rules and forms for ETFs and certain mutual 

funds to report and disclose information related to the liquidity of portfolios.25 In particular, 

the US Securities and Exchange Commission (SEC, or Commission) adopted new Form N-PORT 

which requires specific information about the fund’s liquidity profile to be reported to the 

Commission. In addition, funds are required to provide a narrative regarding their liquidity risk 

management program within each fund’s report to shareholders. Funds are also required to 

disclose principal risks of investing in a fund, including liquidity risk, as applicable.

The objective of the reporting and disclosure is to broadly promote effective liquidity 

management throughout the industry and to enhance disclosure to benefit regulators and 

investors. The reporting and disclosure rules should enable market participants to have insights 

into fund liquidity, and context around the fund manager’s liquidity management processes and 

oversight.

2.5.1 Money Market Funds: Primary Reserve Fund & Subsequent Reforms

One area where liquidity management has been particularly visible is with money market funds. 

In October 2016, the SEC implemented sweeping reform for money market funds. The reform 

of this $2.7 trillion26 part of the market was a direct result of the 2008 collapse of the Reserve 

Primary Fund, a significant victim of the financial crisis that caught certain money market 

investors by surprise. Among other things, the regulation established three definitive 

categories of money market funds - retail, government or institutional (or “prime” funds). The 

rule creates specific restrictions on what investors are allowed to purchase, retail money 

market funds. This distinction is relevant because retail and government money market funds 

can continue to trade at stable (i.e. $1) NAV, but those funds classified as institutional have to 

float their NAV, similar to other open-end mutual funds. In addition, certain money market 

funds are permitted to impose liquidity fees when faced with significant redemptions, and can 

even temporarily suspend withdrawals (known as redemption gates). 

 25 See Securities Exchange Commission, “Investment Company Liquidity Disclosure” (2018), available at: 

https://www.sec.gov/rules/final/2018/ic-33142.pdf. 26 Since the implementation of these rules, over $1 trillion AUM has left or been reclassified from these prime, 

institutional funds. 
21

2.5.2 How to Identify and Manage Illiquid Assets

As stated above, the SEC introduced Rule 22e-4 as a final rule in October 2016, creating a 

minimum standard of liquidity risk management for certain open-end mutual funds, inclusive of 

ETFs, but excluding money-market funds, which are subjected to more strict standards under 

the money market fund reform (described above). Among other things, this rule codifies longstanding guidance preventing funds from having greater than a 15% of NAV exposure to 

holdings classified as illiquid. To conform with this rule, funds are required to classify all 

portfolio holdings into one of four liquidity classifications (i.e. Highly Liquid, Moderately Liquid, 

Less Liquid or Illiquid) based on the number of days it takes to convert the holding to cash (or to

sell/dispose of the asset for the latter two categories) under normal market conditions. Many 

funds have implemented regular and ongoing monitoring of their portfolios as part of their 

written liquidity risk management programs. 

2.5.3 Forward-Looking Disclosures on Frictions in the ETF “In-Kind” Settlement 

In a departure from the original proposal, the SEC was persuaded by industry feedback that 

ETFs have different liquidity profiles than other open-end mutual funds and thus are subjected 

to modified requirements under Rule 22e-4. Firstly, if the ETF redeems in-kind27 (i.e. de 

minimis amount of cash redemptions), then the ETF is exempted from both the liquidity 

classification requirement, as well as a requirement for the fund’s board to set and maintain a 

minimum percentage of portfolio holdings invested in highly liquid investments (known as the 

highly liquid investment minimum). ETFs are also required to consider certain ETF-specific 

factors when assessing, managing and reviewing liquidity risk.28 Finally, Exchange-Traded 

Managed Funds are treated in the same manner as ETFs under the rule.

29

3 ETF and Mutual Funds in Stressed Markets

3.1 Impact of Flows

We turn now to a more detailed examination of how open-end mutual funds and ETFs have 

performed in times of market stress, focusing for the most part on fixed income funds. Recent 

evidence suggests that flow patterns in corporate bond mutual funds exhibit a concave relation 

with performance (Goldstein, Jiang and Ng 2017). That is, fund flows are sensitive to weak 

performance more than they are sensitive to good performance, and that sensitivity is greater 

 27 Via Form N-CEN, there is now public data on this activity. 28 Rule 22e-4(b)(1)(i)(D). These factors are: (i) the relationship between the ETF’s portfolio liquidity and the way in 

which, and the prices and spreads at which, ETF shares trade, including, the efficiency of the arbitrage function and 

the level of active participation by market participants (including APs); and (ii) the effect of the composition of 

baskets on the overall liquidity of the ETF’s portfolio.

29 See Securities and Exchange Commission, “Investment Company Liquidity Disclosure” (2018), available at: 

https://www.sec.gov/rules/proposed/2018/ic-33046.pdf. 
22

when the funds hold less liquid assets and when the overall market illiquidity is higher. In 

contrast, the flow-to-performance sensitivity for equity mutual funds exhibits a convex shape. 

This greater sensitivity of outflows to weaker performance points to the possibility of flowdriven fragility in corporate bond funds, driven in part by the first mover advantage of exiting 

the fund early, since outflows exhibit greater liquidation costs for less liquid funds.

In the context of the possible impact of flows on fixed income market, it is important to keep in 

mind a key difference between fixed income ETF and mutual fund structures in stressed 

markets, namely that transaction costs in an ETF are externalized.

30 In other words, remaining 

investors in mutual fund bear part of the costs of the transaction costs incurred by the 

participants who redeemed or subscribed. In contrast, the sellers of the ETF shares will transact 

directly with buyers at a market determined price. 

Mutual funds can potentially undertake a number of measures to reduce the “externalization” 

problem such as holding more cash and highly liquid securities with lower liquidation costs, 

putting restrictions on redemptions, or possibly an adjustment to the fund’s NAV known as

“swing pricing”31 (Chen, Goldstein and Jiang, 2010; Chernenko and Sunderam, 2016). Since 

mutual funds normally hold a liquidity buffer, they can potentially supply liquidity at times 

when other market participants are forced to sell bonds (Wang, Zhang and Zhang 2018; Anand,

Jotikasthira and Venkataraman 2018). 

Since many ETFs can meet redemption requests32 in-kind, ETFs can invest more in less liquid 

securities with an advantage of minimizing tracking error.33 In theory, when ETF selling activity 

exceeds ETF buying activity, the creation/redemption process in the primary market is used to 

 30 To illustrate, consider a highly simplified example of hypothetical fixed income mutual fund with one million 

shares outstanding trading at say $103 pershare. Suppose on a volatile day that there are $5 million of inflows 

(subscriptions) and $20 million of outflows (redemptions) for a net outflow of $15 million, and the NAV falls to 

$100. In the mutual fund example, subscriptions and redemptions will occur at the new NAV of $100 (we are 

ignoring arbitrage frictions for simplicity) and the fund manager must sell $15 million of the underlying assets. The 

average bid-ask spreads of the underlying assets on this day are (purely for illustrative purposes) assumed to be 

0.20%, and so one-way transaction costs are 0.10%. These sales will tend to occur at the bid price of the 

underlying assets, and hence an average discount of 0.10% to NAV. At the start of the following day, NAV is equal 

to $84,985,000, which is calculated as the original $100 million, minus the $15 million in sold assets, and also 

minus the transaction costs of selling. Net selling does not require the ETF manager to interact with the capital 

markets, meaning investors in an exactly equivalent and hypothetical exchange-traded fund who do not sell will 

hold a fund whose assets are valued at $85 million.

31 In 2016, the SEC adopted rules that allowed certain US open end funds to use swing pricing. See Securities 

Exchange Commission, “Investment Company Swing Pricing” (2016), available at: 

https://www.sec.gov/rules/final/2016/33-10234.pdf. 

Currently, Form N-CEN data indicates this is not being used in the US. 32 Not all ETFs redeemin-kind. 33 Rule 22e-4 under the Investment Company Act prohibits a fund from acquiring any illiquid investment if, 

immediately after such acquisition, it would have invested more than 15% of its net assets in illiquid investments 

that are assets. See Securities Exchange Commission, “Investment Company Liquidity Risk Management Programs; 

Commission Guidance for In-Kind ETFs” (2018), atp. 6, available at: https://www.sec.gov/rules/interim/2018/ic33010.pdf. 
23

handle these imbalances, and any excessive price deviation, thus linking ETFs to the underlying 

securities. Bhattacharya and O’Hara (2018) study a scenario where the underlying securities are 

hard-to-trade, which could reflect securities in less liquid markets, or securities that are 

ordinarily easy to buy and sell but become hard-to-trade under stressful conditions. In such 

scenarios, market makers in the underlying bonds learn from ETF prices and cannot distinguish 

between price changes that are relevant for the pricing the specific bond and those that are not 

relevant. Thus, while ETF trading facilitates price discovery at the portfolio level, the study 

posits that ETFs may lead to persistent price distortions of individual bonds from fundamentals, 

and excessive co-movements in returns of individual bonds. 

Evidence from equity markets suggest that ETF daily returns tend to be negatively autocorrelated and such auto-correlation tends to be more negative when ETF turnover is high, 

consistent with the idea that ETF prices might contain noise that triggers ETF arbitrage (Da and 

Shive, 2017). First, it is well understood that when NAV is stale, ETF returns will be more volatile 

than the underlying index returns. In the view of some researchers, arbitrage activity 

propagates liquidity shocks from the ETF to the underlying stocks and increases volatility (BenDavid, Franzoni and Moussawi, 2017), and contributes to excessive stock return and liquidity 

co-movement among underlying stocks (Da and Shive, 2017). Others argue that any “nonfundamental volatility” is limited by arbitrage bounds and that effects ascribed to ETF flows 

may simply reflect investors’ desires for exposure that are independent of the choice of 

investment vehicle. 

Further research should examine fixed income ETFs and underlying bonds to understand 

whether similar patterns are observed in individual bonds during normal and stress 

environments. This investigation seems particularly relevant for fixed income markets since 

bonds are generally harder to trade than stocks.

3.2 Real-World Examples of Funds in Stressed Markets

Here we present a few real-world examples of stressed markets, and the effects on fund 

liquidity, pricing, and investor flows. These examples – that are not intended to be

comprehensive or representative in any broader sense, but more to flesh out or previous 

discussions – serve to highlight the complexity of real-world responses. Some of the examples

presented show minimal or no impact to fixed income funds while heavily impacting stock 

markets, while others showcase instances of discrete and cyclical impacts on fixed income 

markets.

3.2.1 Taper Tantrum in 2013

Unexpected changes in central bank policy can induce significant shifts in fixed income markets. 

In the summer of 2013, the Federal Reserve unexpectedly proposed ending its quantitative 

easing program, leading to a significant sell-off in fixed income markets. Corporate bond mutual 

funds and ETFs experienced a record outflow of $69 billion in June 2013, with continuing 
24

outflows in subsequent months. Dannhauser and Hoseinzade (2018) study whether the 

outflows to corporate bond mutual funds and ETFs have an impact on the pricing of the 

underlying bonds and whether the price effects get subsequently reversed (i.e., price pressure). 

The study finds that outflows from mutual funds have no significant effect on corporate bond 

yield spreads following the Taper Tantrum while ETF outflows leads to significant yield 

movements that are reversed in subsequent months. In their study, a one-standard deviation 

increase in ETF outflows during the summer of 2013 leads to a 12.6 basis points increase in the 

yield spread of corporate bonds in summer of 2013. The study posits that intraday liquidity of 

ETFs is likely to attract short-term traders who focus on the behavior of other traders, rather 

than on long term fundamentals. The short-term traders tend to sell aggressively in periods of 

turmoil which affects the underlying bonds held by the ETFs. It is also possible that the results 

of Dannhauser and Hoseinzade (2018) reflect the fact that prices of liquid bonds adjust (those 

in the index and hence the ETF) while less liquid bonds do not benefit from the same level of 

price discovery.

3.2.2 Collapse of Third Avenue Credit Focused Fund

Many market participants have questioned whether the fixed income funds – particularly in 

high-yield –can sustain heightened selling pressure driven by redemption flows and trade in an 

orderly fashion during periods of elevated market stress. The collapse of the Third Avenue 

Credit Focused Fund in a time of market stress in late 2015 received considerable press 

attention and provides some interesting insights on this topic. By way of context, this particular 

fund was an actively managed mutual fund specifically focused on very illiquid bonds. Indeed, 

90% of the fund’s holdings (as of 7/31/2015) were rated CCC or lower or were unrated.

In December 2015, the US high-yield corporate bond market saw a surge in volatility associated 

with declining commodity prices. On December 9, 2015, it was announced that the Third 

Avenue Credit Focused Fund (TFCIX) was halting redemptions, news that further exacerbated 

investor concerns surrounding the US high-yield market. The Third Avenue incident rekindled 

fears that high-yield bond funds would be “forced sellers” during periods of already heightened 

selling pressure. During the period surrounding this highly unusual closing of a US mutual fund 

that coincided with selling pressure in the broader high-yield market, data suggests that highyield ETFs may have actually served as a stabilizing force by providing a second source of 

liquidity on exchanges; in December 2015, redemptions in US high-yield ETFs totaled $1.16 

billion vs. $6.4 billion for high-yield mutual funds. 

3.2.3 Flash Events of 2010 and 2015

A broader market issue that concerns both investors and regulators are “flash events,” marked 

by sharp price movements and subsequent reversals in compressed time intervals. In the 

“Flash Crash” of May 6, 2010, the Dow Jones Industrial Average dropped almost 1,000 points in 

20 minutes. Many well-known stocks briefly traded at unreasonable prices, including some that 

traded at pennies. Exchange-traded funds were disproportionately represented among the 
25

securities most affected with prices diverging widely from their underlying NAVs, which led 

some commentators to draw a connection between the sharp market moves on May 6 to the 

pricing and trading of these instruments. 

Madhavan (2012) provides an analysis to explain why an event like the Flash Crash had not 

been observed before in financial market history focusing on market structure changes, 

including increased market fragmentation, high frequency trading, and the proliferation of new 

venues and notes: “The safeguards and reforms that have been implemented in the US equity 

markets should help slow down a potential future market disruption similar to the Flash Crash. 

But they have not eliminated the possibility that another Flash Crash would occur, albeit with a 

different catalyst or possibly in a different asset class.” 

Indeed, flash events have taken place in other asset classes since 2010, including US Treasury 

bonds and currencies, where ETFs assets are minor. On October 15, 2014, the yield on the 10-

year US Treasury note fell to 1.86% before reversing to 2.13% within a 15-minute time interval. 

A Joint Staff Report (2015) by staff of US Treasury, the Federal Reserve, and financial regulators 

found that the intraday yield change was eight standard deviations greater than normal and 

noted: “For such significant volatility and a large round-trip in prices to occur in so short a time 

with no obvious catalyst is unprecedented in the recent history of the Treasury market.” This 

report found that the speed and size of the yield changes seems to trace back to the evolving 

structure of the Treasury market, including the role of automated trading. As another example, 

the value of the UK pound sterling dropped by more than 6 percent against the US dollar in just 

a few minutes on October 6, 2016, falling to a record low of $1.1378 (as reported in McDonald 

2016). A very recent flash event in currencies occurred on January 2, 2019, when the Japanese 

Yen increased 8% against the Australian dollar in just 7 minutes, levels that had been 

maintained for almost a decade. 34 These examples suggest flash events are related to recent 

market structure changes. 

In US equities, a flash event in August 2015 that resembled the 2010 Flash Crash led many 

industry participants including asset managers, brokers, and exchanges, to organize to affect 

many important changes in market structure. It is, however, important to note that these flash 

events were equity market events, affecting equity ETFs and stocks. Fixed income funds 

generally traded smoothly without undue disruption.

3.3 Recent Observations: US High-Yield Markets in 2018

In 2018, we observed considerable volatility in high yield ETFs with negative returns and large 

outflows relative to assets under management. Funds in stressed periods experienced elevated 

secondary exchange volumes, elevated listed options activity, and premiums/discounts in line 

with price discovery and bid-ask spreads of underlying bonds. As of the start of 2018, the US

high-yield market, represented by the outstanding market value of the ICE BofAML US High 

 34 See “Flash-Crash Moves Hit Currency Markets” by Ruth Carson and Michael G Wilson, Bloomberg, January 3, 

2019, available at 
26

Yield Index, was about $1.3 trillion. There are $47 billion of assets in high-yield ETFs, vs $267

billion in high-yield mutual funds that seek to beat a benchmark index (“active mutual funds”).35 

Thus high-yield ETFs represent 3.5% of the US high-yield market while high-yield active mutual 

funds represent 20.5% of the US high-yield market. For the early part of 2018, high-yield active

mutual funds have experienced larger and more volatile flows consistent with past periods of

high-yield fund outflows as shown in Exhibit 7 below. While this is admittedly a narrow 3-

month window of time, it illustrates the broader point that ETF flows are not necessarily more 

volatile than active mutual fund flows.

Exhibit 7:

US high-yield Funds (Active Mutual Funds and ETFs) – 3 Month Rolling Net Flows

Source: Lipper, BlackRock, as of 1/31/2018.

In summary, in observed historic periods of stressed market conditions, ETFs have generally 

served as vehicles of price discovery. The ratio of secondary to primary volume rises in such 

times as buyers and sellers interact on organized exchanges. There is no evidence that fixed 

income funds have had liquidity problems in a limited number of scenarios including the 

collapse of Third Avenue Fund (2015), the Taper Tantrum (2013) and the Flash Crash (2010).

4 A Roadmap for Further Research

The diversity of real-world experiences highlighted in the previous section suggest the 

limitations to what we know. While the discussion so far has focused on summarizing the 

subcommittee’s findings regarding a focused set of topics, we turn now to areas where our 

conclusions are limited and where we feel there is a greater need for research. The 

subcommittee does not have a view on which entities should conduct this research, but rather 

 35 Source: Barclays, Morningstar Direct, as of 1/31/2018.

-$30

-$20

-$10

$0

$10

$20

$30

Feb-11 Sep-11 Apr-12 Nov-12 Jun-13 Jan-14 Aug-14 Mar-15 Oct-15 May-16 Dec-16 Jul-17 Feb-18

3M Rolling Flows ($bn)

Total HY Fund Flows Active HY mutual fund flows HY ETF flows
27

seeks to identify gaps in our understanding and a possible roadmap for future investigation. 

This is also not intended to be an exhaustive list; the subcommittee recognizes that there are 

many important questions that lie beyond the scope of the present report. We see three 

general areas for future research.

First, the theoretical and empirical evidence regarding the impact of the growth in fixed income 

indexing (via mutual funds or ETFs) on the liquidity of the underlying bond markets is not, as we 

have reviewed, conclusive. This is a large, complex and important area for future research. 

This comment also applies to other asset classes. In particular, it would be valuable to quantify 

possible price effects associated with index membership, and also to understand whether the 

existence of ETFs in particular improves or detracts from the liquidity of the underlying bonds, 

and in a related manner, to price discovery at the security level. Further research should 

examine fixed income the underlying bonds held by bond funds to understand whether similar 

patterns are observed in individual bonds during normal and stress environments. This 

investigation seems particularly relevant for fixed income markets since bonds are generally 

harder to trade than stocks.

Second, the evidence to date suggests that premiums and discounts for fixed income ETFs are 

not necessarily evidence of mispricing or of challenges to liquidity. When the ETF share price 

trades at a premium or a discount to the value of the securities held by the ETF, there is an 

economic incentive for creation or redemption. However, such ETF-related, primary market 

trading may36 lead to trading in the underlying constituents as described earlier. Clearly, there 

is scope for more academic research on this subject including the link between primary market 

activity and actionable arbitrage opportunities. As a topic for future study, it would be 

interesting to track the efficacy of the arbitrage process (say using data from form N-CEN) 

under stressful market conditions. Specifically, there is a need to better understand the role of 

Authorized Participants and their activities in relation to market volatility.

Third, as discussed above, flash events highlight the need for further research on liquidity gaps 

in increasingly fast-moving markets, and the role played by market structure and market 

participants, such as high frequency traders. Similarly, there is still much to be learned about 

the behavior of traders and the flows they induce in times of market stress. We would also 

recommend further analysis of whether secondary market trading in fixed income ETFs may 

serve as a source of price discovery and as a way for buyers and sellers to meet without 

necessarily impacting the underlying securities, particularly during periods of market stress.

5 Conclusions

While the increase in demand for fixed income funds is relatively recent, we are able to observe 

some similarities in their function and market impacts to those of more familiar equity 

 36 It is also possible the AP offsets any creation or redemption activity in derivatives markets versus trading 

individual bonds.
28

products. Although the existing body of research on equity ETFs may help inform avenues for 

further research on fixed income ETFs and their market impacts, it is important to understand 

the unique pricing and liquidity characteristics of fixed income markets. Recognition of these 

differences better informs our understanding of the arbitrage mechanism and the roles of APs

in fixed income ETFs. With this understanding, we are better situated to identify potential 

investment and systemic risks associated with fixed income funds, and to begin analyzing 

further observations under, and implications of, stressed market conditions.

The Subcommittee believes this report and its underlying research are comprehensive based on 

market knowledge to-date, however ongoing research on this topic will be useful, especially 

during stressed market periods, given the dearth of specifically relevant research available. 

Further research could address limitations to our current understanding by examining 

relationships between fixed income ETFs and their underlying securities under prolonged or 

unusual conditions. Ongoing research might seek to:

1) Address gaps in our current understanding related to:

• Mutual funds and less liquid holdings;

• Behavior of fixed income ETF investors in extreme risk situations; and

• Potential for APs to exacerbate a stressed market situation through their 

actions up to, and including, simultaneous withdrawal.

2) Evaluate the creation and redemption process pertaining to:

• The number of APs active on any given day under various conditions and 

whether their participation is correlated.

3) Link the collection and categorization of new data sources to data that are currently 

available including:

• Data highlighted in the FIMSAC bond fund subcommittee comment letter on 

investor education37; and

• Transaction level data on bonds and data on fund flows.

As new data on fixed income transactions, liquidity, fund flows, and the actions of market 

participants in volatile environments become available, we might better understand these 

relationships, as well as better clarify unique factors impacting fixed income funds, their 

underlying bonds, investors and the broader fixed income markets.

 37 https://www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-etf-investor-education-and-datarecommendation.pdf
29

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