Stress Testing ETFs: Lessons from the Last Twenty Years

Stress Testing ETFs: Lessons from the Last Twenty Years DAVID B. MAZZA, HEAD OF RESEARCH, SPDR ETFS & JARED ROWLEY, ETF STRATEGIST; STATE STREET GLOBAL ADVISORS In January 1993, the first exchange traded fund (ETF), the SPDR S&P ETF [SPY] was launched as a tool for investors to gain efficient, liquid and cost effective access to the total return of the S&P Index. SPY was designed to trade during regular market hours similar to a common stock. In doing so, it provided investors with physical exposure to all of the underlying constituents of the S&P Index, similar to an index mutual fund. Today, SPY is the world s largest and most liquid ETF with net assets over $146 billion. 1 SPY started an industry that has become an integral and innovative part of the financial system and has grown at a rate of over 2% per year. Important to market participants is the fact that ETFs have performed as they were designed to, even during times of market stress. Consequently, investors have come to rely on ETFs as an efficient vehicle to access a variety of markets and asset classes, especially during periods of disruption. WHY STRESS TEST ETFS? Institutional investors have found that ETFs provide an incremental source of liquidity to the market and can serve as an alternative to future contracts, commingled funds or separately managed accounts. At the same time, financial advisors and individual investors find ETFs to be an attractive vehicle because they provide transparent, liquid and cost effective exposure to a wide range of market segments, many of which were previously unavailable to the individual investor. However, like any relatively new product, ETFs have skeptics. Critics have questioned whether or not ETFs actually deliver on the benefits that ETF providers claim they offer. With the ETF industry celebrating its 2th anniversary in early 212, we are taking a look back to ask the question, have ETFs delivered on their original objectives and provided investors a low cost, tax efficient, liquid vehicle that can be relied on during times of market duress? While there are many ways to test the efficiency of an investment vehicle, we will focus on a specific attribute, which is unique to the ETF structure, examining to what extent ETF prices have remained in parity with their net asset value (NAV) during some of the most difficult market environments in recent history. In general, most ETFs are managed to meet an investment objective of matching the risk/return profile of a given index. This objective is similar to what is employed by other investment vehicles, such as an index mutual fund. However, unlike mutual funds, ETF shares can be created and redeemed in-kind for the underlying shares of the index they are tracking. The creation/ redemption process gives ETFs a unique advantage because when the NAV of an ETF s underlying securities differs from the market price of the ETF, an arbitrage opportunity exists for market makers to profit from these differences, which keeps the market price and NAV of an ETF in relative parity. From an investment perspective, this offers several benefits. One such benefit is that, in the market, prices of ETFs trade closely to their NAV. Furthermore, due to the inkind creation/redemption process, ETFs may avoid generating taxable capital gains, as individual securities are not liquidated for rebalancing or to fund client redemptions. To help investors understand what the NAV of an ETF is on an intraday basis, an indicative net asset value (inav) is published every 1 seconds during the trading day. The inav is an index of the intraday prices of the securities in a fund s most recent creation unit, which serves as a reference point to aid investors in the price discovery of the ETF. 2 When an ETF trades at levels not at parity with the inav, market participants may have an opportunity to capture a profit by trading between the ETF and the underlying securities. With this being the case, stress testing ETFs during a variety of market scenarios that have taken place over the past decade will help to determine whether or not ETFs are a stable investment vehicle in all market environments. We will examine ETFs performance during periods of extreme market stress, such as, the market closures after September 11, 21, trading suspensions of an ETF s key constituent, the market dislocation during the Global Financial Crisis and devastating natural disasters. spdrs.com

SPY S RESPONSE TO THE MARKET CLOSURES AFTER SEPTEMBER 11, 21 The September 11, 21 terrorist attacks against the United States severely damaged the physical and electronic infrastructure of US financial markets. All trading of stocks and bonds was halted immediately after the attacks. The US stock exchanges were closed from September 11 through September 17, the longest stock market closure since the Great Depression. 3 Due to the attacks, investors heavily sold off certain industries and securities that would be most impacted when markets reopened on September 17. In particular, securities in the Airlines industry were sold aggressively, as illustrated in Figure 1. When trading began at 9:3 AM on September 17, there was an unusually large discrepancy between the market price of SPY and the inav of SPY s underlying portfolio, as illustrated in Figure 2. Interestingly, as the individual securities began trading, the inav and market price of SPY converged. The reason for this is that the inav was reflecting stale market values of some securities, which had last traded on September 1, before stock markets were abruptly halted on the morning of September 11. Upon further investigation, the divergence was caused by several securities not opening promptly at 9:3 AM. Since some of these stocks had not yet begun trading, investors were able to discount their prices through SPY itself, which opened normally on September 17. As a result, market participants were able to use SPY s price as an implied valuation for the constituents of the S&P, which allowed SPY to serve as a price discovery vehicle for its underlying securities. While this concept may seem arcane, it is an important one for investors. Not only did the ETF itself function throughout the day, but it provided investors with a tool to express their opinion on the US equity market even as certain securities were not functioning as normal. FIGURE 1: SEPTEMBER 17, 21 SECTOR AND STOCK PRICE CHANGES INDUSTRY PRICE CHANGE (%) STOCK PRICE CHANGE (%) Airlines -32.16 US Airways Group Inc -2.7 Automobiles -13.7 Delta Air Lines Inc -44.9 Hotels Restaurants & Leisure -12.8 Sabre Holdings Corporation -4.91 Internet Software & Services -11.68 AMR Corp. -39.39 Auto Components -11.49 Carnival Corp. -31.87 Consumer Finance Media Specialty Retail -11.18-11.6-1.8 Starwood Hotels & Resorts Worldwide Inc. -28.43 United Technologies Corp. -28.2 Southwest Airlines Co. -24.7 Building Products -1.38 Hilton Hotels Corp. -23.9 Capital Markets -1.31 Source: FactSet, SSgA, as of 9/17/21. Marriott International Inc. -21. FIGURE 2: SPY BID/ASK SPREAD AND INDICATIVE NAV ON SEPTEMBER 17, 21 Price in USD 11 18 16 14 12 1 9:3 11:1 12:4 14:2 1: Bid Ask Intraday NAV Source: Bloomberg, L.P., SSgA, as of 9/17/21. XLI S RESPONSE TO THE TRADING HALT OF A KEY CONSTITUENT Trading halts of individual securities happen on a frequent basis due to earnings announcements, volatile price movements and the announcement of material company news. For example, on September 12, 22, shares of Tyco International [TYC] were halted from the market open until approximately 11:3 AM, due to criminal and civil charges being filed against certain Tyco executives. The charges brought the accusation of embezzlement of company funds and widespread impropriety by company executives. 4 As of September 12, 22, TYC comprised approximately 3.7% of the Industrial Select Sector SPDR Fund [XLI]. XLI provides investors exposure to the industrial sector of the S&P Index. As Figure 3 illustrates, XLI continued to operate efficiently during the trading halt, with a relatively tight bid/ask spread. Considering that a large constituent in the fund was halted from trading, this is a notable result that highlights the resiliency of ETFs. FIGURE 3: XLI BID/ASK, INDICATIVE NAV AND TYC PRICE XLI price in USD 22. 21.8 21.6 21.4 9:3 11: 12:4 14:1 1: Bid Ask Intraday NAV TYC Source: Bloomberg, L.P., SSgA, as of 9/12/22. TYC Price 2 19 18 17 2

FIGURE 4: XLI SHARE VOLUME AND BID/ASK SPREAD Share Volume Bid/Ask Spread as % of Ask 1.3 12.24 FIGURE 6: DAILY XLF BID/ASK LEVELS AND PREMIUM/DISCOUNT Premium/Discount (%) 1 Daily Bid/Ask Levels 32 9.18 24 6.12 16 3.6-8 9:3 11: 12:4 14:1 1:. Volume (Shares) % SPREAD Source: Bloomberg, L.P., SSgA, as of 9/12/22. Only during the 1-minute period immediately before and after TYC resumed trading did the average spread on XLI widen slightly. However, outside of this time period, XLI s average spread was 8 bps, as shown in Figure 4. The wider bid/ask spread during this window is evidence of investors using the ETF as a price discovery mechanism while a key constituent was halted. In other words, investors who wanted to express an opinion on TYC, to do so or were looking for a means to do so held XLI. XLF S PERFORMANCE DURING THE GLOBAL FINANCIAL CRISIS While the Global Financial Crisis impacted markets over a number of years, the worst of it was during the second half of 28. High levels of market volatility were observed during this period. In fact, the CBOE VIX Index reached an intra-year high of over 8, and the S&P Financial Select Sector Index had abnormally large movements in daily returns. Due to their role in the crisis and subsequent uncertainty around their future business prospects, shares of financial services firms were sold off heavily during this time. It is worth considering that, in addition to the bankruptcy of Lehman Brothers Holdings Inc. (LEH), several prominent financial institutions were top constituents of XLF and accepted large amounts of TARP funds from the US Treasury and were targets and/or acquirers in large M&A deals. FIGURE : XLF MARKET PRICE, NAV AND VOLUME Daily XLF and NAV Levels 3 2 2 1 1 Jan Mar May Jul Sep Dec Volume Price NAV Millions 1, 8 6 4 2-1 Jan Mar May Jul Sep Dec Premium/Discount % Ask Bid Source: Bloomberg, L.P., SSgA, 1/2/28 through 12/31/28. During the financial crisis, XLF was (and continues to be) the largest ETF providing exposure to the US financial sector, in terms of AUM and trading volume. XLF experienced a sizable increase in trading volume during the fall of 28, when the average daily trading volume for September and October were, respectively, 27% and 148% of the average daily volume levels during the previous months of the year, as illustrated in Figure. In addition, XLF s shares outstanding increased by 2% and the fund s total net assets were up by 4%, in spite of market volatility and the crisis unfolding across the financial services sector. This demonstrates that market participants had confidence in the ability of XLF to provide liquidity and exposure to the financial sector by accurately reflecting the value of the underlying securities without the risk of single stock exposure. Even as the sector was undergoing major turmoil, and XLF traded at parity with its NAV over the course of the year, as shown in Figure. Unlike the previous two examples, which look at performance over the course of one day, Figure 6 illustrates the resilience of ETFs over an extended period of time. For the majority of the year, XLF s market price traded very closely to its underlying net asset value, as illustrated by the consistently small premium/discount. While XLF did experience wider than normal premiums and discounts on occasion during the fall months, this was not the case by the end of the year. This further serves to highlight how the ETF functioned as it was designed to and proves that the ETF structure was able to withstand turmoil in the industry over an extended period of time. JSC S RESPONSE TO A NATURAL DISASTER The SPDR Russell/Nomura Small Cap Japan ETF [JSC] trades on the NYSE, but the underlying Japanese securities trade on Japanese exchanges. More specifically, over 9% of JSC s securities trade on the Tokyo Stock Exchange (TSE). This creates an illustrative stress testing example, as the time zone differential causes the ETF s underlying securities to stop trading at 3: PM (JST), while JSC begins trading at 9:3 AM (EST), a difference of eight hours and thirty minutes. Source: Bloomberg, L.P., SSgA, 1/2/28 through 12/31/28. 3

At approximately 2:4 PM (JST) on Friday, March 11, 211, a devastating category 9 earthquake struck Japan, which subsequently generated a powerful tsunami that struck the eastern coast of the island nation. In addition to severe flooding and major damage to buildings and infrastructure, the earthquake and tsunami severely damaged several Japanese nuclear facilities that generated a significant amount of Japan s electricity. The combined impact of the earthquake, tsunami and nuclear crisis was catastrophic for the people of Japan, the Japanese economy and financial markets. Remarkably, the TSE remained open without any trading halts. In fact, the TSE remained open through the entirety of the crisis without any disruption. 6 During periods when Japanese exchanges were closed, market participants had the most current information available to trade JSC, even though the valuations of the fund s underlying securities were based on prices that incorporated information from eight hours earlier, when the securities traded in Japan. Moreover, while investors were actively seeking price discovery of JSC, the fund s inav would not have reflected real-time prices for the underlying equities. The inav was partly reflecting stale security prices from the previous trading day, along with other inputs used to compute inav. The JSC premium and discount relative to inav reflects expected valuations of securities that were not trading at the time, but were being affected by the most recent news coming out of Japan, and an inav that incorporated somewhat stale valuations. When JSC swung to a 7.6% premium during the March 1 trading session in the US, it preceded the +7.3% performance of the benchmark securities during the March 13 trading session in Japan. Over the following days, as the extent of the earthquake damage became fully known, the premium/ discount and volume levels of the ETF reverted to more normal ranges. Figure 8 highlights the increased trading activity in JSC. This serves as a powerful example of international investors relying on ETFs for price discovery when certain global markets are closed due to time zone differences. XLK S RESPONSE TO A TRADING HALT OF A KEY CONSTITUENT DURING MARKET HOURS While sharing similarities to the XLI example offered above, the intraday halt of Google Inc. [GOOG] provides an additional example of an ETF functioning properly and serving as a price discovery tool for the market, despite elevated intraday volatility and trading halts of a constituent security. As of October 18, 212 GOOG was the fifth largest holding of the Technology Select Sector SPDR [XLK], representing 6.3% of the ETF s AUM. At approximately 12:3 PM on October 18, 212, the financial printing company, RR Donnelley, prematurely announced the third quarter earnings of GOOG. 7 Google s earnings substantially missed analysts estimates, which caused the price of GOOG to plunge to such an extent that a trading halt was placed on the shares at 12: PM, and remained in place for several hours. The Google sell-off caused XLK to trade at a 17bps discount to its inav for a brief period, which is illustrated in Figure 9. However, within minutes the discount tightened, and was within normal ranges before GOOG rebounded from its intraday low and before the halt. The sequence of these events is a crucial detail because it demonstrates that the market price of XLK was anticipating a more accurate valuation of GOOG. Furthermore, XLK s premium/discount range remained within a tight range after the halt on GOOG was lifted, and GOOG shares ended the day over 1% higher than the halt price. The discount is important because it implies that XLK may have been oversold relative to the level that the inav would indicate. However, in reality this was likely not the case. In this particular situation, the discount was likely caused by two separate issues: a technical issue regarding the inav calculation and the overselling of GOOG. In the case of GOOG on October 18, share prices were falling so rapidly that the fifteen-second inav calculation interval was not rapid enough to represent the current GOOG market price. FIGURE 7: JSC PREMIUM/DISCOUNT AND RUSSELL/NOMURA SMALL CAP INDEX LEVELS FIGURE 8: JSC ABSOLUTE AND RELATIVE VOLUME IN MARCH 211 Daily Premium/Discount (%) Daily JSC Bid/Ask levels Relative March Volume Daily Volume Levels (Thousand) 8 7 2 7 4 67 2 6 9 1 4-4 1 1 3-8 43 1-12 1 Mar 1 Mar 29 Mar 12 Apr 26 Apr 3 1 Mar 6 Mar 11 Mar 16 Mar 21 Mar 31 Mar Premium/Discount % Russell/Nomura Small-Cap Index Bid Ask Volume % of Trailing One Month % of Average Trailing Twelve Months Source: Bloomberg, L.P., SSgA, 3/1/211 through 4/29/211. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund. Source: Bloomberg, L.P., SSgA, 3/1/211 through 4/29/211. 4

FIGURE 9: XLK PREMIUM/DISCOUNT AND GOOG PRICE FIGURE 1: XLK PREMIUM/DISCOUNT AND GOOG PRICE XLK Premium/Discount (%) GOOG Price XLK Premium/Discount (%) GOOG Price.2 76.2 76.1 74.1 74. 72. 72 -.1 7 -.1 7 -.2 9:3 1:47 12:4 13:21 14:38 1: 68 -.2 12:2 12:31 12:37 12:43 12:49 12: 68 Premium/Discount (%) GOOG Price Source: Bloomberg, L.P., SSgA, 1/18/212. Thus, the inav was reflecting a stale price and exacerbated the magnitude of the discount in XLK. In addition, GOOG fell by 9.7% in the first eight minutes after the earnings release, rebounded by 3.2% just three minutes later, and finally was halted at $687.3, which was still 1% above the lowest price reached by the initial fall. The significance of this is that GOOG appears to have been oversold. The 17 bps discount in XLK suggests that XLK was also slightly oversold. The immediate reversal of the XLK discount suggests that the market participants had some degree of confidence that XLK was oversold relative to the value of the underlying securities, specifically GOOG. This event is another example of an ETF trading at parity with its underlying securities, in spite of a trading halt of a key constituent and a heightened level of volatility. Premium/Discount (%) GOOG Price Source: Bloomberg, L.P., SSgA, 1/18/212. CONCLUSION Twenty years after the industry s inception, it is clear that ETFs have delivered for investors. Based on how ETFs have behaved in periods that include market closures, constituent trading suspensions, the market dislocation during a Global Financial Crisis, natural disasters and human errors, it is evident that ETFs add an incremental source of liquidity to the market. ETFs are also a mechanism for investors to uncover the true value of security prices even when the traditional means of doing so are constrained. Over the next 2 years, there may be new and different stresses placed on financial markets. With the introduction of ETFs to the marketplace and the varied and numerous ETF funds available, investors now have a strong tool at their disposal to implement investment ideas with a precise focus. In fact, the drivers of the industry during the last 2 years will likely remain the same over the next 2, and with the continued interest by investors, ETFs may continue to be their mechanism of choice.

ABOUT SPDR ETFS SPDR ETFs are a comprehensive fund family of over 1 ETFs, spanning an array of international and domestic asset classes. Offered by State Street Global Advisors, SPDR ETFs provide investors with the flexibility to select investments that are precisely aligned to their investment strategy. Recognized as the industry pioneer, State Street created the first ETF in 1993 (SPDR S&P Ticker SPY). Since then, we ve sustained our place as an industry innovator through the introduction of many ground-breaking products, including first-to-market launches with gold, international real estate, international fixed income and sector ETFs. For information about our ETF family, visit spdrs.com. STATE STREET GLOBAL ADVISORS State Street Financial Center One Lincoln Street Boston, MA 2111 866.787.227 spdrs.com 1 Bloomberg, L.P., SSgA, as of 9/3/213. 2 https://etp.nyx.com/en/node/366. 3 Report for Congress. The Economic Effects of 9/11: A Retrospective Assessment. September 27, 22. pp. CRS-28. 4 Andrew Ross Sorkin. Sweeping Charges Expected for Tyco s Ex-Chief and 2 Others The New York Times. September 12, 22. http://www.nytimes.com/22/9/12/business/sweepingcharges-expected-for-tyco-s-ex-chief-and-2-others.html?ref=tycointernational Financial Select Sector SPDR Fund. https://www.spdrs.com/product/fund.seam?ticker=xlf 6 Efforts in Crisis Management: Information related to the Great East Japan Earthquake. Tokyo Stock Exchange. http://www.tse.or.jp/english/about/bcp/earthquake211.html 7 http://blogs.wsj.com/marketbeat/212/1/18/rr-donnelley-ceo-early-google-filing-was-human-error/ FOR PUBLIC USE. IMPORTANT RISK INFORMATION ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. This material is for educational and illustrative purposes only. State Street and its affiliates are not affiliated with any company mentioned herein. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. There can be no assurance that a liquid market will be maintained for ETF shares. The use of short selling entails a high degree of risk, may increase potential losses and is not suitable for all investors. Please assess your financial circumstances and risk tolerance prior to short selling. Passive management and the creation/redemption process can help minimize capital gains distributions. The Fund invests by sampling the index, holding a range of securities that, in the aggregate, appoximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Select Sector SPDR Funds bear a higher level of risk than more broadly diversified funds. All ETFs are subject to risk, including the possible loss of principal. Sector ETFs products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. The funds presented herein have different investment objectives, costs and expenses. The performance of each fund will necessarily depend on the ability of their respective managers to select portfolio investments. These differences, among others, may result in significant disparity in the funds portfolio assets and performance. For further information on the funds, please review their respective prospectuses. Frequent trading of ETF could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. STANDARD & POOR S, S&P and S&P are registered trademarks of Standard & Poor s Financial Services LLC. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products. Further limitations and important information that could affect investors rights are described in the prospectus for the applicable product. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., a registered broker-dealer, is distributor for SPDR S&P, SPDR S&P MidCap 4 and SPDR Dow Jones Industrial Average, and all unit investment trusts. ALPS Portfolio Solutions Distributor, Inc. is distributor for Select Sector SPDRs. ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc. are not affiliated with State Street Global Markets, LLC. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 866.787.227 or visit spdrs.com. Read it carefully. 213 State Street Corporation. All Rights Reserved. ID298-IBG-117 Exp. Date: 12/31/214 IBG.STETF.1213 SPD688 6