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The Impact of ETFs on Volatility in Underlying Markets

The growth of ETFs in recent years has been nothing short of spectacular, with total assets in US-listed ETFs now totaling approximately $1.5 trillion. Not surprisingly, as ETFs become increasingly large and important, interest in whether they directly affect underlying markets is growing.

Two papers issued recently address this issue. The first, from Fitch Ratings, explores the impact of the growth in fixed-income ETFs, particularly ETFs providing exposure to the high yield and corporate markets. The Fitch paper notes that corporate fixed income ETFs have become increasingly important in the markets, particularly since dealers in the underlying securities have reduced their inventories of bonds in response to increased regulation and capital and liquidity requirements. The report also notes that the trading volume in corporate fixed income ETFs have increased significantly this year. From this, Fitch concludes that while ETFs provide a significant benefit to investors who wish to quickly enter or exit the market, “increased ETF trading volumes might also amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds.”

Second, a report authored by Tugkan Tuzan, an economist with the Federal Reserve Board, explores the impact of leveraged and inverse ETFs on market volatility. The report notes that not only do leveraged ETFs (that is, ETFs that attempt to provide their investors with a multiple of an index’s performance on a given day) trade in the same direction as the market as they rebalance, but that their trading may be predictable, and thus could attract “opportunistic traders.” Tuzan notes that this can increase volatility in underlying markets, and that the impact can be greater as volatility in the underlying market increases.

To access the full Fitch paper, click here (free registration is required). The paper on leveraged ETFs is available here