How Volatility and Commodity ETFs Impact the Markets
Exchange Traded Funds (ETFs) have undeniably transformed the financial industry, providing investors with unprecedented ease of access to diverse portfolios. However, their impact on the market isn’t uniformly positive. The surge in ETF popularity has raised concerns about potential distortions and increased market fragility. Critics argue that the sheer size and speed of ETF trading might exacerbate market volatility, especially during periods of stress. While ETFs offer advantages in terms of liquidity and cost, their rapid growth prompts a closer examination of their effects on market dynamics and the potential challenges they pose to overall financial stability.
Reference [1] proposed breaking down the impact of volatility and commodity ETFs into three main components: calendar rebalancing, flow rebalancing, and leverage rebalancing. The author pointed out,
The paper also provides a novel decomposition of ETF demand into three main components: calendar rebalancing due to futures roll, flow rebalancing due to fund inflows and outflows, and leverage rebalancing due to the maintenance of a constant daily leverage. The framework is flexible to accommodate various types of ETFs, including equity and fixed income ETFs. Leverage rebalancing has the largest impact on the price gap. This type of ETF trading amplifies price changes and introduces unhedgeable risks for ETF counterparties, exposing them negatively to variance.
The results from this research show that ETFs affect prices of underlying assets in the current era of an increasingly large ETF presence. While ETFs can increase liquidity and trading volume by attracting new capital, they also withdraw liquidity during extreme market times. These effects could be magnified if ETFs were used by unsophisticated, short- horizon investors. The termination of the largest inverse VIX ETF in 2018 and the extreme events and ETF closures in the oil market in 2020 are prominent examples of such effects.
In short, leverage rebalancing is the most impactful factor on ETF-related price components. This particular rebalancing process not only magnifies price changes but also subjects ETF counterparties to increased exposure to volatility.
Let us know what you think in the comments.
References
[1] Karamfil Todorov, When Passive Funds Affect Prices: Evidence from Volatility and Commodity ETFs, Review of Finance, November 2023
So true. ETFs can be an excellent investment option for individuals, especially in a market where most people are stock pickers. But, on the other hand, as you said, "ETF trading might exacerbate market volatility, especially during periods of stress."
Taking equity ETFs as an example, as new money flows into an equity index ETF, the fund manager is obligated to buy the stocks that make up the index. This includes the good, profitable companies, as well as the bad, unprofitable companies. That money inflow lifts all stocks in the index, from good to bad.
But when the market turns (crashes, etc.), the money outflow from ETFs punishes all companies in the index, from good to bad, exacerbating market volatility.
But this could also be a good opportunity. If, for example, the market goes down, a savvy investor could short-sell or buy puts for the bad companies that should get hammered by ETF sellers and stock pickers and wait until the good companies are available at exaggerated discounts and buy them then.
https://ffus.substack.com/p/equity-index-etfs-new-hidden-risks