How ETF Growth Is Impacting Asset Pricing
We conducted an interview with the authors to get a better grasp on what they felt were the most important ideas spawned from their research. I also spent some time reviewing the theorems derived in the paper. The core findings with respect to ETFs and their effects on asset pricing are as follows:
- Market Efficiency Increases: ETFs, or “composite securities,” should improve overall price efficiency, and the impact is bigger for relatively illiquid assets. However, the authors do make the point that firm-specific news might actually get incorporated into prices more slowly. Ironically, as algo-driven ETFs displace “stock-pickers,” stock-pickers might find that their nuanced information collection abilities could become more valuable.
- Volatility and Correlations Increases: ETFs could increase asset volatility and correlations across baskets that have similar systematic factor exposures. On one hand, this is to be expected if systematic factor exposures are being priced more accurately. On the other hand, portfolio diversification assumptions of the past may not hold into the future, if the diversification benefits across composite portfolios increases.
- Mixed Liquidity and Price Impact Effects: The authors find that transaction costs and liquidity impact might increase for illiquid securities. However, the authors find that overall costs to trade securities driven by systematic factors may decrease when traded via composite securities such as ETFs.
The key insight I gleamed from this new research is that understanding the impact of the enormous rise in ETF popularity is complicated and unclear.
Moreover, when viewing the growth of ETFs, one must understand if we are seeing a net increase in factor investor or simply a shift from mutual funds to ETFs. If the net dollars allocated to composite securities hasn’t really changed, we may see little impact on financial markets.
Of course, if the ETF revolution is truly democratizing and enlarging the tent for factor investors, the implications from Will and Doug’s new paper become more relevant.
Wesley Gray (@alphaarchitect) is the CEO and CIO of Alpha Architect, a quantitative asset manager based near Philadelphia that focuses on delivering focused value and momentum factor exposure via their ETFs (QVAL, IVAL, QMOM and IMOM).