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The market slump last week was the most severe since 2008. And yet no large ETFs imploded.gopixa/ISTOCK

Exchange-traded funds (ETFs) have radically changed the face of capital markets. Today, a significant chunk of the world’s stocks and bonds are held in these passive funds that typically track an index.

ETFs have long provoked questions. In a rapidly falling market, will investors be able to sell ETF units in an orderly manner? If there are no buyers, can ETF managers sell the bonds they hold quickly enough to free up money for departing investors?

On both counts, the answer last week was yes.

Passive funds have become popular with investors because they are cheap and tend to perform just as well as more expensive, actively managed funds. Their growth since the financial crisis has mirrored a bull run in stocks. Investors have suffered severe losses only in brief dips.

The market slump last week was the most severe since 2008. And yet no large ETFs imploded. The largest stock-focused funds experienced some of their busiest days of buying and selling and continued to function as they should.

Bond ETFs have also grown quickly, surpassing US$1-trillion in assets under management. They give investors access to large baskets of debt securities and can be redeemed throughout the day – not just at the end of the day, as with mutual funds.

Such funds were subject to persistent worries that they would exacerbate the effects of sell-offs. Some observers feared that when enough investors in a bond ETF pull out their money, managers would struggle to sell the less liquid bonds, pushing down prices further and triggering yet more outflows.

So, it’s notable that bond funds tracking riskier assets also held up while the underlying markets sold off last week. Investors yanked a record amount of money from junk bond ETFs and mutual funds, preferring the safety of government bonds.

The world’s largest junk bond ETF, BlackRock Inc.’s iShares iBoxx $ High Yield Corporate Bond ETF (HYG-A), accounted for more than half of these outflows – including US$1.5-billion in a single day. But the selling seemed orderly. Bonds were sold and the money was handed back to departing investors.

The ETF’s price did fall below the value of the bonds it holds – a signal of stress – but not for long, notes Samara Cohen, BlackRock’s co-head of iShares markets and investments.

“Last week was an extraordinary risk-off market but an orderly sell-off,” she says.

Todd Rosenbluth, head of mutual fund and ETF research for CFRA Research, says it was a “real-world example of bond ETFs adding liquidity to the fixed-income market,” which is something that promoters of these securities have long argued.

Others remain skeptical that the mechanics will continue to function as smoothly, if markets tumble for longer.

“That selling pressure would have tightened at some point,” says Liz Young, director of market strategy for BNY Mellon Investment Management.

The debate will run and run.

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