Do ETFs Cause Market Volatility?

New paper argues that it does - but flows aren't the main problem.

May 7, 2014

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anxiety roller coaster stressInvestors—retail and institutions alike—love their exchange-traded funds (ETFs). They’re simple and cheap to use, and they provide all-important liquidity when you need it. Plus, they’ve opened up an entirely new universe of investments to individuals and professionals who otherwise wouldn’t have been able to access those asset classes. But as the ETF space has grown, regulators have been grappling with their effects on the overall market—do they create instability? And, if so, how?

A new research paper looks at the link between ETFs and stock prices and provides the first real data to show that, in some cases, ETF use can create market instability—depending, of course, on what you’re doing with them.

The paper, called “Do ETFs Increase Volatility”, uses variation in ETF ownership across stocks, as well as variation in ETF mispricing and ETF flows, to measure the effects of ETFs on the volatility of the underlying securities. The data show that ETF ownership does increase stock volatility, but not necessarily as a result of flows in and out of ETFs (the usual culprit when it comes to such studies).

Rather, the greatest volatility seems to come from arbitrage trades between the ETF and the underlying stocks. As more and more investors use ETFs for speculative purposes, “ETFs are increasingly exposed to non-fundamental demand shocks. If arbitrage is limited, these shocks can propagate from the ETF market to the underlying securities.”

As the authors explain it:

…consider for example a large liquidity sell order of ETF shares by an institutional trader…arbitrageurs buy the ETF and hedge this position by selling the underlying portfolio. If arbitrageurs have limited risk bearing capacity, their demands are not perfectly elastic and they require compensations in terms of positive expected returns. Hence, the selling activity leads to downward price pressure on the underlying portfolio. As a result, the initial liquidity shock at the ETF level is propagated to the underlying securities, whose prices fall for no fundamental reason. In this sequence of events, arbitrageurs’ activity induces propagation of liquidity shocks from the ETF to the underlying securities.

The upshot according to the paper’s authors? Arbitrage could cause more problems than it solves when it comes to ETFs. The data is a welcome addition to the growing body of research about how ETFs work and what role they play in capital markets—and for plan sponsors making large and sophisticated trades, it could just be helpful for identifying when arbitrage will work—and when it won’t.

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