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Stocks’ Price Volatility Increased by ETF Ownership

The growth of exchange-traded funds (ETFs) has increased the levels of daily price volatility in stocks held by a fund. Ownership by an ETF increases a stock’s daily volatility by 16%. A National Bureau of Economic Research working paper cites arbitrage as the reason why.

The structure of ETFs makes them suitable for arbitrage. ETFs can be bought and sold throughout the trading day. Because their portfolios are transparent, it is easy for a trading firm, such as a hedge fund or a high-frequency trader, to determine if an ETF is trading at a premium or a discount to its net asset value. If an ETF trades at a premium, for instance, a trader can sell the ETF short and buy the stocks in the fund’s portfolio and wait for prices to converge. If traders sense a large demand imbalance for an ETF, they can buy the underlying stocks and then redeem the portfolio to the ETF provider. The latter action occurred on 71% of the trading days in the study sample.

Another contributing factor is the growth of ETFs themselves. The average fraction of an S&P 500 stock’s market capitalization held by ETFs has grown from 0.27% in 2000 to 3.78% in 2012.

The effect of this trading is greater volatility in the prices of the underlying stocks. S&P 500 stocks incur a 21% standard deviation increase in intraday volatility when they are owned by ETFs. Daily turnover of shares is also higher. The paper’s authors rule out “the explanation that ETFs are merely replacing investors that without the ETFs would trade directly in the stocks.”

Individual investors concerned about the increase in price volatility may want to consider focusing more on small-cap stocks. Reduced liquidity and higher transaction costs reduce the volatility created in these stocks by ETF arbitrage, even though ETF ownership of small-cap stocks has also increased.

Source: “Do ETFs Increase Volatility?” by Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi, NBER Working Paper 20071, April 2014.


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