Can ETFs affect U.S. financial stability? A quantile cointegration analysis

2019

Exchange-traded funds (ETFs) belong to the fastest growing investment products worldwide. Within 15 years, total assets invested in ETFs have twenty-folded, reaching over $3.7 trillion at the end of 2018. Increasing demand for passive investments, coupled with high liquidity and low transaction costs are key advantages of ETFs compared to their closest substitutes such as traditional index funds. Besides the continuous growth of ETFs, the Flash Crash in 2010 triggered detailed investigations by regulators on how ETFs affect the financial market. This literature review gives the reader a broad overview of recent academic studies analysing the effect of ETFs on liquidity, price discovery, volatility and comovement of the underlying securities.

Financial Markets and Portfolio Management, 2020

Exchange-traded funds (ETFs) belong to the fastest growing investment products worldwide. Within 15 years, total assets invested in ETFs have twenty-folded, reaching over $3.7 trillion at the end of 2018. Increasing demand for passive investments, coupled with high liquidity and low transaction costs, are key advantages of ETFs compared to their closest substitutes such as traditional index funds. Besides the continuous growth of ETFs, the Flash Crash in 2010 triggered detailed investigations by regulators on how ETFs affect the financial market. This literature review provides a broad overview of recent academic studies analyzing the effect of ETFs on liquidity, price discovery, volatility, and comovement of the underlying securities.

The buy and hold stock market strategy, which gained tremendous popularity in the 1970s, may no longer be such a profitable method for accumulating wealth for the average investor in the new millennium. This paper investigates the relationship between compound return and holding period length to see how long an Exchange Traded Fund (ETF) investment must be held before a positive return on principal is 100% likely. Because the ETF is a relatively new investment vehicle that could be considered particularly well-suited to the requirements of the buy and hold strategy, we begin our investigation here. We find that the compound returns earned over a rolling holding period are much more volatile than one might assume given historic rules of thumb for average return expectations. Using monthly return data for all listed NASDAQ ETFs between their date of inception and 2015, we find it takes ten years for the average probability of a gain on principal to be over 95 percent.

SSRN Electronic Journal, 2019

We examine how exchange traded funds (ETFs) affect asset pricing, volatility and trade volume in a laboratory asset market. We consider markets with zero or negative correlations in asset returns and the presence or absence of composite ETF assets. We find that when the returns on assets are negatively correlated, the presence of an ETF asset reduces mispricing and price volatility without decreasing trading volume. In the case where returns have zero correlation, the ETF asset has no impact. Thus, our findings suggest that ETFs do not harm, and may in fact improve, price discovery and liquidity in asset markets.

International review, 2023

The increasing popularity of exchange-traded funds (ETFs) among retail and professional investors necessitates a deeper understanding of their value-creation process. Recognizing inconsistencies between stated investment strategies and portfolio exposures is crucial for appropriate rebalancing in accordance with investment policy statements. Against the backdrop of evolving investment factors during the pandemic and changing geopolitical circumstances, the performance of ETFs has undergone significant shifts. Analyzing the directional changes of prevailing investment factors within specific macro environments is essential for optimizing portfolios composed out of ETFs. This study has a dual objective: firstly, to comprehend the dominant investment factors and their dynamics in the U.S. market, and secondly, to evaluate the performance of ETFs that adhere to specific investment philosophies and strategies. To achieve these objectives, the Fama-French three and fivefactor models were employed to analyze a dataset comprising 72 U.S. ETFs. These ETFs were then categorized into four portfolios based on investment style and size. Performance appraisal measures were utilized to compare portfolios on a risk-adjusted basis relative to the benchmark. The bear market that commenced in early 2022 had a universally negative impact on observed ETFs due to their longonly exposures. This inflection point also marked a shift in the relative performance between value and growth styles, as well as the outperformance of more conservative investing approaches, underscoring the importance of adapting to changing market conditions. Additionally, the absence of a size premium throughout the observed period confirms investors' preference for large-cap stocks as a resilient factor. Furthermore, the size effect exerted a universal negative influence due to the size drift of ETFs employing a stated large-size investment strategy. During the observed period, the value style experienced a significant recovery, characterized by higher book-to-price ratios, operating profits, and more conservative investment policies that produced superior results compared to the previous longer period. The findings of this research enhance our understanding of the influence of investment factors on U.S. ETF performance, providing valuable insights for investors and portfolio managers who may need to adjust their strategies in response to observed changes in market dynamics.

Financial Markets, Institutions & Instruments, 2008

This paper investigates the performance of U.S. and country exchange traded funds currently traded in the United States and provides new insight into their pricing. While the U.S. funds are priced closely to their net asset values, the country funds are not and can exhibit large, positive autocorrelations in fund premium. The mispricing of country funds is related to momentum, illiquidity, and size effects. We also find an inverted U-shaped relationship between fund premium and market liquidity, which suggests that more active trading does lead to lower mispricing but only after a certain level of liquidity is reached.

North American Actuarial Journal, 2007

Actuaries manage risk, and asset price volatility is the most fundamental parameter in models of risk management. This study utilizes recent advances in econometric theory to decompose total asset price volatility into a smooth, continuous component and a discrete (jump) component. We analyze a data set that consists of high-frequency tick-by-tick data for all stocks in the S&P 100 Index, as well as similar futures contract data on three U.S. equity indexes and three U.S. Treasury securities during the period 1999-2005. We find that discrete jumps contribute between 15% and 25% of total asset risk for all equity index futures, and between 45% and 75% of total risk for Treasury bond futures. Jumps occur roughly once every five trading days for equity index futures, and slightly more frequently for Treasury bond futures. For the S&P 100 component stocks, on days when a jump occurs, the absolute jump is between 80% and 90% of the total absolute return for that day. We also demonstrate that, in the cross section of individual stocks, the average jump beta is significantly lower than the average continuous beta. Cross-correlations within the bond and stock markets are significantly higher on days when jumps occur, but stockbond correlations are relatively constant regardless of whether or not a jump occurs. We conclude with a discussion of the implications of our findings for risk management.

Journal of Economics and Business, 1999

International Journal of Financial Studies

The buy and hold stock market strategy, which gained tremendous popularity in the 1970s, may no longer be such a profitable method for accumulating wealth for the average investor in the new millennium. This paper investigates the relationship between compound return and holding period length to see how long an Exchange Traded Fund (ETF) investment must be held before a positive return on principal is 100% likely. Because the ETF is a relatively new investment vehicle that could be considered particularly well-suited to the requirements of the buy and hold strategy, we begin our investigation here. We find that the compound returns earned over a rolling holding period are much more volatile than one might assume given historic rules of thumb for average return expectations. Using monthly return data for all listed NASDAQ ETFs between their date of inception and 2015, we find it takes ten years for the average probability of a gain on principal to be over 95 percent.

Journal of Economics and Finance, 2009

In this paper, we study the price deviations of the three most liquid Exchange Traded Funds (ETFs): the Spiders (S&P500 tracking ETF); the Diamonds (Dow Jones Industrial Average tracking ETF); and the Cubes (NASDAQ 100 tracking ETF). The price deviation is stationary and predictable, and therefore can be considered an additional, implicit transaction cost (in addition to the bid-ask spread, and the explicit transaction costs, such as brokerage and maintenance fees). The reason for the predictability of the pricing deviation stems from its stationarity, clustering of volatility, specific price discovery processes, lead-lag relationships and dividend accumulation and distribution for this asset class. We conduct a comprehensive study of ETF pricing deviation and provide new perspectives for the performance evaluation literature which is using a static benchmark. The current state of computational technology allows for more precise computations when benchmarks for performance such as accounting for different costs associated with the selection of a benchmark are used.