A related finding the authors address was that serial correlation of stock markets became more negative following indexation, with the argument being that index products impound nonfundamental shocks (which then revert) into the underlying security prices.
Ben-David, Franzoni and Moussawi also examined the literature on ETFs during periods of market turmoil. The concern is that during market turbulence, market makers and arbitrageurs cease intermediation activities because they do not have reliable pricing information. As a result, their absence can lead to illiquidity in the underlying securities, the amplification of shocks, and their transmission to other assets.
The evidence shows that ETFs have, in fact, displayed a high level of illiquidity during times of market turbulence. And importantly, liquidity shocks travel across assets because they are informationally connected.
Ben-David, Franzoni and Moussawi concluded: “ETFs are perhaps the financial innovation that has had the greatest impact on financial markets in the first decades of the 21st century. These investment vehicles offer a combination of the features that have not been available to investors before: low cost transactions, intraday liquidity, and passive index tracking. The rise of ETFs is part of a wider process that has taken place in the asset management industry over the last three decades: passive management has expanded, while at the same time the asset management landscape has become more concentrated.”
They added: “On the one hand, researchers have found that ETFs allow information to be more efficiently impounded into security prices. On the other hand, mounting evidence indicates that securities prices have become noisier since the introduction of ETFs. It is possible that both phenomena are taking place in parallel: security prices impound information more efficiently once they are included in ETFs’ baskets and, at the same time, become more volatile due to non-fundamental reasons.”
Finally, the authors also warn: “There is a concern that ETFs provide a false sense of liquidity, where they are liquid at normal trading environment. However, at turbulent times, liquidity dries up since authorized participants (those who create and destroy ETFs) and arbitrageurs stay out of the market. The effect could be exacerbated if the presence of ETFs crowds out liquidity from the underlying assets (e.g., corporate bonds).”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.