Exchange Traded Funds and Stock Market Volatility

• Published date: 01 December 2017
• Author: Liao Xu,Xiangkang Yin
• Date: 01 December 2017
• DOI: http://doi.org/10.1111/irfi.12121

Exchange Traded Funds and Stock

Market Volatility*

LIAO XU

†

AND XIANGKANG YIN

‡

†

International Institute for Financial Studies, Jiangxi University of Finance and

Economics, Nanchang, China and

‡

Department of Economics and Finance, La Trobe University, Bundoora, Victoria,

Australia

ABSTRACT

This study investigates the relationship between the volatility of stock market

indexes and the trading volumes of their exchange traded funds (ETFs). Using

both ordinary least squares and generalized autoregressive conditional

heteroskedasticity approaches, we demonstrate that the contemporaneous

trading volume of S&P 500 ETFs is a key determinant of S&P 500 volatility at

both monthly and daily frequencies. Vector autoregressive estimation on the

other hand suggests a two-way Granger causality between S&P 500 volatility

and the trading of S&P 500 ETFs. A replication analysis of other market

indexes and the corresponding ETFs tracking these indexes confirms that

these findings are robust.

JEL Codes: G12; G14

Much attention has been paid by academics, practitioners, and regulators over

the decades to the volatility of price and/or return in financial markets. Research

on the issues associated to exchange traded funds (ETFs) has also grown rapidly

since the birth of the first ETF in January 1993. It seems an intriguing study to

build a bridge across these two fields. The aim of this paper is to unveil the

relationship between the volatility of a market index and the trading volume of

the ETFs that track the index. This research not only is highly valuable to

academic analysts and market practitioners but also has significant regulatory

implications because they are concerned about the role of ETFs in increasing

the volatility of their associated markets.

1

It is well known that trading volume is a substantial contributor to the

volatility of stock returns.

2

However, less is known about how the trading of ETFs

* The authors would like to thank Jae Kim and the seminar participants at La Trobe University for

their constructive comments.

1 See Ben-David et al. (2014) for a summary of regulators’concerns about ETFs’role in increas-

ing market volatility.

2 For an excellent survey,see Karpoff (1987).

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12121

International Review of Finance, 17:4, 2017: pp. 525–560

DOI: 10.1111/irfi .12121

© 2017 International Review of Finance Ltd. 2017

as financial derivatives affects the volatility of the market index they are tracking.

ETFs are related to their underlying index and the constituent securities of the

index primarily through two channels. First, ETF shares are created by the ETF

issuer who transfers its shares to its authorized participants (APs) in exchange

for the equivalent value of a portfolio of index constituents. Similarly, ETF shares

are redeemed when the ETF issuer trades a portfolio of the constituent securities

of the index with an AP in exchange for the equivalent value of ETF shares. Thus,

as demand and supply pressure in the ETF market induces the APs to create or

redeem ETF shares, it triggers them to sell and purchase index constituents and

in turn fluctuates the index. Second, to keep an ETF closely tracking its target

index, the ETF sponsor announces the net asset value (NAV) under its manage-

ment every 15 s on all trading days. Therefore, if the price of an ETF’s share

deviates from its NAV, arbitrageurs can reap profits from trading the ETF shares.

However, to hedge the risk in ETF trading, arbitrageurs must at the same time

trade in the underlying securities markets in the opposite direction to cover their

exposure in the ETF market. They hold their positions until the price of the ETF

share and its NAV converge, and then they close down the positions to realize

arbitrage profits. Thus, we argue that the trading volume of ETFs that track a

market index should be closely correlated with the price movement and

volatility of the tracked index. We study the S&P 500 index and its ETFs in detail

because this index covers the stocks with a market capitalization of 75% US

equities and the index’s ETFs have the longest history of all ETFs. We then extend

our analysis to other major stock indexes and their associated ETFs.

The study contributes to the literature on ETFs and market volatility in the

following ways. First, to explicitly relate ETF trading to the volatility of the under-

lying index, we quantitatively examine the effect of the trading volume of S&P

500 ETFs at both monthly and daily frequencies. When an ETF issuer announces

its NAV every 15 s, it is likely to provide an arbitrage opportunity if the ETF price

deviates considerably from the NAV. These high-frequency intraday activities

undertaken by arbitrageurs can be better captured by S&P 500 volatility at a daily

frequency.

3

On the other hand, APs may trade less frequently in the constituent

markets to rebalance their portfolios, as the APs’creation and redemption of the

ETF shares are usually (but not necessarily) through trading with the ETF issuer

near the close of a trading day or afterhours trading. Their less frequent trading

activities are probably more relevant to S&P 500 volatility at a monthly

frequency.

4

Moreover, high-frequency intraday return data are only available

from 1996, while low-frequency data cover a longer period. Therefore, we

conduct our analysis using both monthly and daily time series. It is found that

the contemporaneous ETF trading volume in both absolute and relative terms

3 The daily time series of realized variance used in this paper are estimated on the basis of the 1-

min intraday returns of the index. We also estimated the realized variance using 15-s intraday

returns and have found no qualitative difference.

4 The monthly data of realized variance used in this paper are estimated on the basis of the daily

returns of S&P 500 index.

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has an economically and statistically significant effect on the volatility of index

returns. Moreover, the trading volume of ETFs that track S&P 500 index has

stronger power in explaining S&P 500 volatility relative to the control variables.

This thereafter suggests that ETF trading volume is a critical determinant of the

index’s volatility, in addition to the volatility determinants that have been found

in the existing literature.

Second, most existing studies analyzing the relationship between trading

activities and return volatility focus on the concurrent effect in the markets of

individual securities. This paper not only extends the analysis to the interaction

across two related markets but also examines the effects of lagged ETF trading and

S&P 500 volatility. Vector autoregressive (VAR) estimation using both monthly

and daily data presents evidence that the lagged ETF trading affects the volatility

of the index, whereas conversely, the lagged index volatility affects the trading

volume of ETFs. This means that while the trading of S&P 500 ETFs Granger

causes S&P 500 index to be more volatile, the index’s volatility also Granger

causes ETF trading volume to increase. Although the Granger causality does

not imply the actual causality,this finding provides additional evidence of strong

interaction and close correlation between the volatility of S&P 500 index and the

trading of its ETFs. The result of the two-way Granger causation is intuitive.

While a more volatile index is likely to be accompanied by a larger trading

volume of ETFs, the high volatility of the index implies that the ETF prices are

more likely to frequently deviate from the fundamental value of the underlying

index, which creates buying and selling pressure on the ETF market. This

two-way Granger causality is consistent with what Roll, Schwartz, and

Subranhmanyam (2007) find about the two-direction interaction of price shocks

between the futures and equity markets.

In addition, the linear trend analysis of the monthly time series suggests that

the advent of S&P500 ETFs in January 1993 is associated with the acceleration of

S&P 500 volatility growth. The time series of S&P 500 volatility shows an upward

trend over August 1962 to December 2013. However, the trend is slightly steeper

after January 1993, which coincides with the introduction of the first S&P 500

ETF. Empirical evidence also indicates that S&P 500 volatility had a structural

break in January 1993 and this break is statistically significant by certain

measures. Consistent with this structural break, it is found that S&P 500 index

has experienced a greater persistence on volatility shocks since January 1993.

All these findings imply that the introduction of ETFs is likely to generate a shock

to the underlying stock index, because a new ETF creates a new derivative market

with dedicated investors and arbitrageurs focusing on this market.

The strong interaction between the volatility of a market index and the

trading volume of its ETFs is not limited to the S&P 500 index. Extending our

examination to a small-capitalization index in the USA and other market indexes

around the world, we can draw a similar conclusion that the contemporaneous

trading volume of ETFs is a significant determinant of their index’s volatility.

Furthermore, there is a two-direction Granger causality between an index’s

volatility and the trading volume of its associated ETFs.

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