Itzhak Ben-David of The Ohio State University and NBER, Francesco Franzoni from USI Lugano and the Swiss Finance Institute and Rabih Moussawi from the Villanova University and WRDS, University of Pennsylvania set about the question in a Fisher College of Business working paper last updated in November 2017.
By looking at before and after effects of stocks entering or leaving various Russell indices in the U.S. from 2000~2015 they were able to conclude, ETFs do increase volatility. Along the way they make the point that ETFs, although like futures in many ways are sufficiently not like futures to have attracted a whole new crowd of short term operators. These liquidity-dolts don’t add anything to price discovery and the short term effects of their action is usually reversed within 40-days (half within 10-days) of initial liquidity shocks.
The effect is bigger for big stocks as often the creators of ETF liquidity will use ‘optimized replication’ to create units or liquidity depending on the direction of the flow. Optimized replication is about being mostly right in terms of tracking error and avoiding the higher transaction costs associated with dealing in smaller stocks.
The study period includes the Financial Crisis and so it’s been possible to see if the effect is magnified in times of stress, and it is. With over 1/3 of daily volume now accounted for by ETF trading in the U.S. this effect is significant and given the popularity of these instruments only likely to increase in time.
Some of the stock price action in the last two months has almost certainly been the direct result of this process. Something fans and providers of these increasingly dangerous instruments are unlikely to want to investigate further or share with the rest of us if they know this to be the case (it is).
I’ve been saying for some time, and will go on saying; the next major dislocation in global financial markets will have ETFs at it’s core. As they get bigger, more widely adopted and more complicated the danger increases. These are not benign risk-less solutions to investor demand. They are shadowy, largely unregulated, volatility accelerants; and the paper highlighted today provides substantial proof. Regulators the world over will only reach the same conclusion, as they always do with financial innovation, when it’s too late. You may consider yourself forewarned.
You can read the paper in full via this link Do ETFs Increase Volatility?
Happy Sunday.