Swedroe: ETFs’ Side Effects

Assets in global exchange-traded funds (ETFs) rose from about $70 billion in 2000 to more than $4.5 trillion by the end of 2017. This dramatic growth has raised a variety of concerns about the possible detrimental impacts of these flows on underlying securities—with many arguing that substantial flows into ETFs and other index vehicles have increased comovements and volatility in returns of constituent securities.

Recent Research

Ananth Madhavan and Daniel Morillo contribute to the literature with their study, “The Impact of Flows into Exchange-Traded Funds: Volumes and Correlations,” which appears in the summer 2018 issue of The Journal of Portfolio Management.

The authors examined whether the substantial flows into ETFs have impacted volatility and securities comovement as well as the ability of active managers to generate alpha. Their study covered the period 1926 through 2017. Following is a summary of their findings:

• Although cross-stock correlations rose in the period when ETF assets increased, they are not at unprecedented levels relative to the past, well before the rise of passive indexing. Moreover, cross-stock correlations dropped in the period 2014 through 2017, whereas ETF and index assets reached new records.
• Changes in pairwise correlation are driven by macro effects and not by growth in ETFs—the key driver of correlation dynamics is time-series variation in market volatility.
• The common component captured by proxies for macroeconomic uncertainty is sufficient to explain overall levels of correlation. The fact that a large portion of the trading that takes place in response to the common component of information happens in the form of ETF trading is evidence that ETFs are a convenient, low-cost mechanism to price such information.
• The macroenvironment is the main driver of returns and volumes in underlying stocks—there is no evidence that trading in ETFs reduces volumes in the underlying instruments.
• As we should expect, manager alpha is positively related to the idiosyncratic return dispersion—the greater the dispersion, the greater the opportunity to generate alpha—which reflects the macroenvironment, not the state of indexing.
• Active mutual fund managers are less able to succeed through security selection when market volatility and common factor risk dominate in terms of the variation in returns.

Conclusion

Madhavan and Morillo concluded: “There is no empirical evidence that ETF flows have affected the correlation structure of returns, the liquidity of underlying securities or the ability of managers to generate alpha. In other words, all the complaints about the impacts of ETFs are ‘much ado about nothing.’

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.