Current Research On How ETFs Can Affect Financial Markets

We’ve heard a lot of questions recently from clients and readers regarding how ETFs might affect financial markets.

The short answer is “nobody knows.” The long answer is researchers are trying to figure it all out.

In this piece we inventory some of the more interesting research articles on the subject and encourage readers to explore these articles in depth.

How ETFs Might Influence Markets

I’ve already written a bit about how ETFs are impacting asset prices via an article I shared at ETF.com. Here is a link. The piece discussed some work from Lin William Cong and Doug Xu, which delivered 3 core predictions:

Market Efficiency Increases: ETFs, or “composite securities,” should improve overall price efficiency, and the impact is bigger for relatively illiquid assets. However, the authors do make the point that firm-specific news might actually get incorporated into prices more slowly. Ironically, as algo-driven ETFs displace “stock-pickers,” stock-pickers might find that their nuanced information collection abilities could become more valuable.

Volatility and Correlations Increases: ETFs could increase asset volatility and correlations across baskets that have similar systematic factor exposures. On one hand, this is to be expected if systematic factor exposures are being priced more accurately. On the other hand, portfolio diversification assumptions of the past may not hold into the future, if the diversification benefits across composite portfolios increases.

Mixed Liquidity and Price Impact Effects: The authors find that transaction costs and impact costs might increase for illiquid securities. However, the authors find that overall costs to trade securities driven by systematic factors may decrease when traded via composite securities such as ETFs.

This research is great, but there are other researchers with equally compelling and insightful thoughts on how the ETF vehicle might affect the markets. They also bring more data to the theoretical discussion.

For example, we conducted an interview with Zahi Ben-David, who co-authored some great work with Prof. Francesco Franzoni (University of Lugano) and Prof. Rabih Moussawi (Villanova University) on ETFs and their influence on the stock market. Their original paper is posted here and their survey paper is posted here. A summary of their research findings in the words of Zahi:

Our main result is that ownership by ETFs cause prices of the underlying stocks to be noisier. This is a causal claim, i.e., the ownership by ETFs increases the volatility of the underlying stocks. We know that this volatility is noise since sharp changes in flows at the ETF level causes price changes in underlying stocks, which tend to reverse after a few days.