Market on Tilt: ETF Trading and Market Quality
Posted: 14 Jan 2020 Last revised: 22 Oct 2020
Date Written: September 28, 2020
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: Suggested Citation