Exchange-traded funds, liquidity and volatility

Abstract

Given the exponential growth in exchange-traded fund (ETF) trading, ETFs have become a significant factor in the volatility generating process of their largest component stocks. A simple model of trading is developed for securities that are included in ETFs, and empirical support is provided for the model hypotheses. Volatility spillovers from ETFs to their largest component stocks are economically significant. These spillovers are increasing in liquidity, the proportion of each stock held by the fund, deviations from net asset value, ETF flow of funds and ETF market capitalization. The results are consistent with a positive volume–volatility relation and trading-based explanations of volatility, and are generally stronger for smaller stocks.

Keywords:

• exchange-traded fund
• ETF
• volatility spillover
• liquidity
• volume

JEL Classification:

• G12
• G14

Notes

¹ This is accomplished via the mechanism of ‘creation’ and ‘redemption’ units at large institutions that are designated ‘authorized participants’ (APs).

² Further evidence is provided by Chordia et al. (2002), French and Roll (1986), Haugen (2010) and Haugen et al. (1991).