Exchange-traded funds (ETFs) have become popular thanks to such benefits as high liquidity, cost efficiency, and low-cost diversification. ETFs also attract short-horizon liquidity traders, however, which contributes to higher price volatility of securities within the ETF basket. Stocks with high ETF ownership generate a significant risk premium. It would thus appear that the volatility brings about a new source of systematic risk.
What Is the Investment Issue?
Exchange-traded funds (ETFs) have become popular thanks to such benefits as high liquidity, cost efficiency, and low-cost diversification. ETFs also attract short-horizon liquidity traders, however, which contributes to higher price volatility of securities within the ETF basket. Because the increase in stock volatility brought about by ETFs is partly nondiversifiable, it may represent systematic risk for investors with a short-term horizon. As a result, stocks with high ETF ownership may require a risk premium.
How Did the Authors Conduct This Research?
The authors use data from CRSP, Compustat, Bloomberg, and OptionMetrics to identify ETFs traded on the major US exchanges and extract returns and prices. They focus on ETFs that are listed on US exchanges and whose baskets contain US stocks. They consider only plain-vanilla products that engage in physical replication. Leveraged and inverse-leveraged ETFs that use derivatives to deliver the performance of the index are not included in the analysis. Active ETFs that are below 1% of the assets under management in the sector are also omitted. The authors subsequently use the Thomson Reuters Mutual Fund Ownership database as their source of ETF holdings data for the sample. Their final dataset contains 454 distinct equity ETFs, which provide holdings information for 93% of all domestic equity ETFs in the United States between January 2000 and December 2015.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors show that ETFs attract investors with high turnover. ETFs are typically more liquid than the basket of underlying securities in terms of bid–ask spread, price impact, and turnover and thus appeal to short-term investors.
The authors also find that stocks with high ETF ownership tend to display higher volatility than similar securities. They then provide evidence that demand shocks in the ETF market imply a mean-reverting component in asset prices, which suggests that the increase in stock return volatility is unlikely to be attributable to an improvement in price discovery brought about by ETFs. It seems to emanate from a transmission of nonfundamental demand shocks from the ETF market to the prices of the underlying stocks via arbitrage. The authors also demonstrate that the intensity of arbitrage activity between ETFs and their baskets magnifies the effect of ETFs on volatility.
The authors show that portfolios of stocks with high ETF ownership display positive alphas relative to a variety of asset pricing models. These alphas could be as high as 0.50% a month.
The authors find a significant and positive relationship between ETF ownership and stock-level volatility. A one standard deviation increase in ETF ownership corresponds to a 0.14% increase in returns. The authors also note that ETFs add noise to stock prices after using variance ratios. ETF ownership increases the negative autocorrelation in stock prices. A long–short portfolio of the top minus the bottom quintiles of stocks by ETF ownership is seen to generate a return premium of up to 0.50% monthly. The relationship between ETF ownership and volatility furthermore seems to increase with the availability of arbitrage capital.
Portfolio managers, short-term traders, and investors interested in investing in ETFs will find the conclusions of this research useful.
The study covers only a fairly short period, 2000–2015, when the ETF industry was in a growth phase. It would be interesting to see whether the findings still apply over a much longer (e.g., 20-year) period. Furthermore, ETFs made up only 7.05% of the S&P 500 Index market capitalization in 2015, which seems too small for them to have a major impact on price volatility.