Does ETF Trading Affect the Efficiency of the Underlying Index?

Abstract

This study finds that both contemporaneous and lagged ETF trading volumes in both absolute and relative terms are significant contributors to the price efficiency of the underlying index. The creation/redemption of ETF shares is also positively associated with the index efficiency but it weakens the effect of ETF trading on the index efficiency. Moreover, the synthetic ETF price dominates the index in information share and the dominance increases in ETF trading. However, the relation between an individual ETF’s information share and its trading volume varies, which is significantly positive for the dominant ETF but ambiguous for other ETFs.

Keywords: Exchange Traded Fund, Financial Market Index, Price Efficiency, Information Share, Price Discovery

JEL Classification: G12, G14