The Heterogeneous Effects of ETFs on Asset Markets

51 Pages Posted: 14 Jan 2020 Last revised: 29 Jul 2022

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: July 28, 2022

Abstract

Passively tracking an index involves tradeoffs, the most basic of which is to minimize tracking error while controlling transaction costs. This paper shows that exchange-traded funds (ETFs) systematically underweight or omit illiquid index assets. As a result, ETFs have heterogeneous effects on underlying asset markets. Using an instrumental variables approach, we find that the trading activity of ETFs harms liquidity and price efficiency and increases volatility and co-movement for liquid assets, but has no effect on illiquid assets. Our results show that the effects of passive investing on asset markets depend on how passive intermediaries replicate their target index.

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

JEL Classification: G11, G12, G20

Suggested Citation

Brogaard, Jonathan and Heath, Davidson and Huang, Da, The Heterogeneous Effects of ETFs on Asset Markets (July 28, 2022). 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

HOME PAGE: http://dahuang-finance.github.io

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