ETFs and Market Fragility

story_images_sheep-herdDo exchange-traded funds make markets more fragile? And do they make them more volatile, despite assurances that they act as shock absorbers by introducing an extra layer of liquidity?

Such questions have yet to be answered in a meaningful or – importantly – data-driven way. Until now, that is – a new paper by Ayan Bhattacharya and Maureen O’Hara seeks to determine whether or not ETFs contribute to market fragility by promoting herding and creating instability through shocks that are unrelated to the fundamental value of an asset.

The paper will be presented at the 2017 Northern Finance Association Conference, which is being held in Halifax, Nova Scotia from September 15-17.

By focusing on ETFs based on hard to trade assets like fixed income, Bhattacharya and O’Hara show that ETF markets do help move underlying prices closer to fundamental value – but “at the level of individual assets, it may lead to persistent distortions from fundamentals. Assets with high beta and high weightage in the ETF are especially vulnerable to such distortions.”

The paper also shows that herding can arise – “When ETF market makers cannot instantaneously synchronize their price with underlying prices through the arbitrage mechanism, market makers in the ETF and underlying markets set initial clearing prices based on order flow in their own markets, and then revise them as they see prices in other markets evolve.”

This offers the opportunity for speculators to enter the picture as they seek to correctly “guess the information flow from other markets.”

As the authors conclude, ETFs are no longer simply appendages to the market – they are now capable of “affecting markets in their own right.”

You can read the full paper here.