Tuesday, August 6, 2019

Everything you need to know about ETFs and volatility on a 3X5 card

While there are significant benefits and cost advantages from ETF, their growth has impacted the price process for assets. Research suggests that ETFs have an impact on the volatility of the underlying assets associated with the ETF through a short-term liquidity effect. This research is a few years old so the impact may only be greater today with the continued rise in ETF volume. (See for example "Do ETFs Increase Volatility" Journal of Finance December 2018.) 

This volatility discussion is more important because of the strong growth in ETFs with underlying assets that are less liquid. For example, the strong growth in fixed income ETFs, especially with high yield indices, creates an environment where the underlying bonds within the index will see higher volatility based on the flows associated with the ETF. 

ETFs have attracted shorter-term traders (higher turnover clientele) than the underlying assets, so their activity spills-over to the assets included in the ETF. Liquidity traders, not new price discovery, increase negative autocorrelation in the underlying assets. The increasing endogenous risk from changes in market structure from growing ETF usage may have gone unnoticed by many investors in the current relatively low volatility environment, but a change in the environment that may see more rebalancing and asset allocations will spill-over to volatility and co-movement of individual assets. 

The next financial crisis will be different from the last and the impact of ETF flows may be an important part of the future market dislocations. The new "bank runs" will be in financial assets and not just depository institutions. The impact from large inflows and outflows from ETFs will increasingly dominate the behavior of individual assets. This increased price noise will reduce price discovery and create a less healthy market infrastructure. Investors should prepare for these changes with what I will call ETF shock plans.

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