SMITH BRAIN TRUST – Amid news about the Covid-19 pandemic, recent volatility in financial markets and potentially devastating economic impacts, investors have been feeling pretty jittery these days.
It may be a relatively new feeling for many of the people who invest in capital markets via the fast-growing exchange-traded fund industry, which doubled in size in less than four years to reach $6.4 trillion at the end of 2019. Many touted the investment tools as a low-cost and highly liquid strategy for investors.
But do they also contribute to market volatility? In new research, Maryland Smith’s Russell Wermers and two co-authors conduct an empirical study of how ETFs might affect the liquidity of the stocks they hold. For example, Wermers asks, would the exchange-traded funds improve or impair market quality?
“There were competing arguments on this,” says Wermers, the Dean’s Chair in Finance at the University of Maryland’s Robert H. Smith School of Business and director of Maryland Smith’s Center for Financial Policy.
On one hand, he explains, ETFs might divert uninformed traders from holding and trading individual stocks, if their intention was to place a low-cost, diversified bet on a sector or strategy, rather than on the fortunes of a single company. Those diversions would therefore leave mostly the more-informed traders invested in individual stocks, which would reduce the liquidity.
On the other hand, ETFs might lure more uninformed traders into the market – amatuer traders looking for a low-cost way to bet on a certain sector – and that might result in an increase in the investor base for all stocks owned by an ETF. Those new uninformed traders would increase the liquidity of stocks.
In his research, now in the working paper stage, Wermers doesn’t tackle the specific question, as other research has done, of whether ETFs increase the volatility of underlying stocks. Instead, he focuses on the impact of ETFs on liquidity. “While liquidity and volatility are highly correlated, volatility is not the only driver of liquidity,” he notes.
In fact as Maryland Smith’s Albert “Pete” Kyle establishes in his landmark research, dubbed “Kyle ’85” by Nobel laureates and others, the trading volume of uninformed traders is positively related to liquidity.
In the latest research, Wermers uses a difference-in-differences methodology for large changes in the index weights of stocks in the S&P 500 and NASDAQ 100 indexes, and finds that increases in ETF ownership are associated with increases in commonly used measures of liquidity. Stocks with high ETF ownership have higher price resilience and lower adverse selection costs, the research finds.
Using several measures of liquidity, the researchers determined the ETFs do increase the liquidity of their underlying assets.
“We use a previously undiscovered S&P 500 addition pattern to explore the impact of ETFs,” the researchers write. “Stocks that are added to the S&P 500 but removed from the S&P MidCap 400 index experience a decrease in their ETF holdings whereas stocks added to the S&P 500 index outside of the S&P universe experience an increase in their ETF ownership.”
The divergence in ETF ownership provided the researchers with an identification strategy to explore the impact of ETF on the liquidity of the stocks they hold. They found that illiquidity measures, effective spreads, quoted spreads, the Amihud measure of illiquidity and implementation shortfall all increase when the ETF ownership of the stock goes down.
They also found that when there is higher ETF ownership, there is lower adverse selection costs for market makers. But Wermers notes that the relationship between ETFs and lower transaction costs come with two important caveats.
First, stock investors may benefit from these lower transaction costs only under normal conditions. In 2011, when the U.S. debt ceiling crisis was at its peak, sell trades in stocks with high ETF ownership incurred higher transaction costs. The result was consistent with ETFs draining liquidity from their underlying stocks and increasing their transaction costs during market stress.
Second, Wermers notes, it’s important to remember that improvement in liquidity results can only be related to “plain-vanilla equity ETFs.” It is unclear whether other exchange-traded products – leveraged and inverse ETFs, synthetic ETFs, corporate bond ETFs, and volatility ETFs, for example – can have liquidity benefits for their underlying securities even under normal times.
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