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Università della Svizzera italiana - USI

Do ETFs Increase Stock Volatility?

Professor Francesco Franzoni, Director of the USI Institute of Finance
Professor Francesco Franzoni, Director of the USI Institute of Finance

Institute of Finance

Exchange Traded Funds (ETF) have become increasingly popular among investors in recent years. This appeal derives from their ease of trading and because they allow for a more diversified investment portfolio at a lower cost. However, there have been some recent concerns about the role of ETFs in financial markets, particularly about their effect on the stability of stock prices. Professor Francesco Franzoni, Director of the Institute of Finance at USI (Faculty of Economics) and Senior Chair at the Swiss Finance Institute, tackles this issues in his article “Do ETFs Increase Volatility?” soon to be published in the prestigious Journal of Finance.

ETFs appeared on the financial markets in the mid-1990s, and are effectively “passive” investment funds that replicate the performance of indexes, mainly of equities and that, unlike traditional mutual funds, are listed on an exchange, so that they trade through the day just like regular stocks. Essentially, with an ETF an investor can ‘buy’ all the securities that form a given index, without having to buy them one by one (think of the S&P 500, which contains indeed five hundred shares), and therefore at much lower costs. ETFs have been so successful that the assets under management by these funds currently equal those managed by traditional index funds.

In cooperation with colleagues Itzhak Ben-David (Ohio State University) and Rabih Moussawi (Villanonova University), Prof. Franzoni analyzes the data covering ETFs listed on US exchanges between 2000 and 2015. The authors start from the observation that a large part of the trading volume generated by ETFs that track the S&P 500 index is due to arbitrage-driven investors who buy and sell ETFs, and simultaneously sell and buy the underlying shares. The effect of these transactions is to transfer market dynamics (supply and demand) from ETFs to individual equities, thereby increasing market volatility and possibly the risk of shocks. This evolution in the ETF market may result in negative effects on the price stability of financial instruments, as recently observed with the collapse of the popular ETF “XIV” which led to an increase in volatility in the stock market.

The study of Prof. Franzoni and his co-authors is featured in the June issue of the “Practitioner Roundups”, the monthly publication of the Swiss Finance Institute – the Foundation supported by Swiss banks and banking associations, and by six Swiss universities (including USI), which is engaged in basic research, training and knowledge transfer in the financial sector. Banking finance is one of the fields of study offered by USI’s Master in Finance: www.mfin.usi.ch

The full research article is available at: https://bit.ly/2HcixI1