Do ETFs Increase Liquidity?

Coverage of the 2018 Northern Finance Association Conference

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whirlpool waterBy the end of January 2018, net assets of exchange-traded funds in the U.S. reached $3.6 trillion – a 25% jump from the year before. However, the steep rise in ETF assets over the last 15 years has also raised questions about how they could affect the liquidity of their underlying stocks. To address this, two researchers — Mehmet Sağlam from the University of Cincinnati, and the Federal Reserve Board’s Tugkan Tuzun — study ETF liquidity using a dataset of large institutional trades and by measuring implementation shortfall to captures the cumulative impact of trading costs.

Sağlam and Tuzun’s paper, “Do ETFs Increase Liquidity,” will be presented at the upcoming Northern Finance Association Conference, where Canadian Investment Reviewis proud to be a media sponsor for the fourth year in a row.

The authors look at large changes in the portfolio weights of the stocks in the S&P 500 and the NASDAQ 100 indexes and find that increases in ETF ownership decrease the transaction costs of stocks. Their findings also suggest that “high ETF ownership stocks have high price resilience, consistent with arbitrageurs transmitting liquidity from ETFs to individual stocks.”

However, stock investors may only benefit from lower transactions costs under normal conditions. Based on data from the 2011 U.S. debt ceiling crisis, the authors find that sell trades in high ETF ownership stocks incurred higher transaction costs. So, during times of market stress, ETFs drain liquidity from their underlying stocks and increase their transaction costs.

You can read the full paper here.

 

 

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