Market on Tilt: ETF Trading and Market Quality

Posted: 14 Jan 2020 Last revised: 22 Oct 2020

See all articles by Jonathan Brogaard

Jonathan Brogaard

University of Utah - David Eccles School of Business

Davidson Heath

University of Utah - David Eccles School of Business

Da Huang

University of Utah - David Eccles School of Business

Date Written: September 28, 2020

Abstract

Exchange traded funds (ETFs) that track a specified index are a financial technology that has risen dramatically in the last two decades. We model an ETF's optimal index replication strategy and show that it involves underweighting or omitting illiquid index assets. Instrumenting for ETF trading activity, we find that documented effects of ETFs on asset markets differ or even flip sign depending on an asset's preexisting liquidity. These effects are stronger for ETFs that explicitly sample their underlying index. The results show that the effects of ETFs on underlying asset markets are determined by their index replication strategy.

Keywords: exchange-traded funds, passive investment, index, replication strategy, liquidity

JEL Classification: G11, G12, G20

Suggested Citation

Brogaard, Jonathan and Heath, Davidson and Huang, Da, Market on Tilt: ETF Trading and Market Quality (September 28, 2020). Available at SSRN: https://ssrn.com/abstract=3510359 or http://dx.doi.org/10.2139/ssrn.3510359

Jonathan Brogaard

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

HOME PAGE: http://www.jonathanbrogaard.com

Davidson Heath (Contact Author)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

Da Huang

University of Utah - David Eccles School of Business ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States

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