Passive Funds Actively Affect Prices: Evidence from the Largest ETF Markets

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See all articles by Karamfil Todorov

Karamfil Todorov

London School of Economics & Political Science, Department of Finance

Date Written: November 14, 2019

Abstract

This paper studies the size and source of exchange-traded funds’ (ETFs) price impact in the most ETF-dominated asset classes: volatility (VIX) and commodities. I show that the introduction of ETFs increased futures prices and decreased realized returns. To identify ETF-induced price distortions, I propose a model-independent approach to replicate the value of a VIX futures contract. This allows me to isolate a non-fundamental component in VIX futures prices, of 18.5% per year, that is strongly related to the rebalancing of ETFs. To understand the source of that component, I decompose trading demand from ETFs into three main parts: leverage rebalancing, calendar rebalancing, and flow rebalancing. Leverage rebalancing has the largest effects. It amplifies price changes and introduces unhedgeable risks for ETF counterparties. Surprisingly, providing liquidity to leveraged ETFs turns out to be a bet on variance, even in a market with a zero net share of ETFs. Trading against leverage
rebalancing delivers large abnormal returns and Sharpe ratios above two across markets.

Keywords: ETF, passive investing, commoditization, VIX, price impact, leverage

JEL Classification: G11, G13, G23

Suggested Citation

Todorov, Karamfil, Passive Funds Actively Affect Prices: Evidence from the Largest ETF Markets (November 14, 2019). Available at SSRN: https://ssrn.com/abstract=

Karamfil Todorov (Contact Author)

London School of Economics & Political Science, Department of Finance ( email )

London
Great Britain

HOME PAGE: http://ktodorov.com

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