Predictable ETF Order Flow and Market Quality
13 Pages Posted: 8 Oct 2014 Last revised: 21 Aug 2015
Date Written: August 2015
Research on certain types of institutional order flow has highlighted potential destabilizing effects on market quality related to the fact that these orders can be anticipated by other market participants. Examples include the rebalancing of rules-based indexes and ETFs, including end-of-day rebalancing of leveraged and inverse ETFs, rebalancing to maintain target asset weights and option hedges, and rolls out of expiring futures contracts. The goal of this paper is to provide a deeper analysis of the infrastructure that exists and the issues that arise from the execution of predictable institutional orders, with emphasis on order flows related to ETF activity. Considering the roles of information and competition, predictable orders should typically have minimal effects on prices because they are not motivated by fundamental information, they attract natural counterparties, and they benefit from additional liquidity supply. Empirical research on the price effects of ETF trading or other forms of predictable order flow should be guided by relevant economic theory and a full appreciation of the infrastructure that exists to facilitate such execution. Estimates of the price effects of ETF trading or other forms of predictable order flow are unlikely to be accurate unless the researcher can also measure other order flow that is correlated with the predictable order flow being studied.
Keywords: ETFs, Predictable Order Flow, Frontrunning, Volatility
JEL Classification: G19
Suggested Citation: Suggested Citation