We spend a lot of our time thinking and learning about ETFs, since they are a critical new investor weapon in the war for after-tax investment returns. And we are always trying to understand better what the academic community is saying. (here is a recent example on ETF.com)
Luckily, it happens that an old friend of mine from the University of Chicago’s PhD program is among the world’s foremost academic experts on ETFs. It’s a match made in heaven — we want to hear what the academics are saying about ETFs and we know just the guy to talk to!
Itzhak Ben-David is a tenured finance professor at Ohio State University’s Fisher College of Business, and has done a lot of research and writing on the subject of ETFs.
We posted recently on Zahi’s new ETF overview paper, which includes some interesting thoughts on liquidity, and limits to arbitrage.
We thought we’d share with our blog readers some thoughts on these and other issues relating to ETFs from Professor Ben-David, who goes by “Zahi.”
–Interview begins
Zahi, can you start out with a little background on yourself and how you got interested in ETF research? Doesn’t seem like a hot topic in academic journals…yet…
Zahi: Thank you for covering my work! We indeed met 15 years ago at the University of Chicago, Booth School of Business, where we both did our PhD in Finance. Since then, I grew older by 15 years, have a wonderful wife and four beautiful daughters. In the last nine years, I have been with The Ohio State University. I am a finance professor and also the academic director of the Ohio State Center for Real Estate.
Most of my time is spent on academic research (check out https://fisher.osu.edu/~ben-david.1/). My main research areas include financial markets, behavioral finance, household finance, and real estate. I am very interested in the industrial organization of the asset management industry, and how its transformation in the last few years affects securities market.
As you may recall, during the PhD years we talked much about how investment behavior affects what we observe in markets. Investors ETFs are no different: their behavior affects the prices of ETFs and the price of the underlying securities.
My research on institutional investors in general, and ETFs specifically, is in collaboration with Prof. Francesco Franzoni (University of Lugano) and Prof. Rabih Moussawi (Villanova University). The ETF project started in 2010, when we realized the ETFs could potentially affect the market more than originally intended to. Our paper was a pioneer in this space; currently, there is a lot of research in the area, so we wrote also a survey article that reviews the academic papers in this field.
Our original paper is posted on: https://ssrn.com/abstract=1967599
The survey paper is posted on: https://ssrn.com/abstract=2865734
You mention that ETFs add noise to the market? Can you quantify that a bit for us and pinpoint how this might be relevant to the common investor?
Our main result is that ownership by ETFs cause prices of the underlying stocks to be noisier. This is a causal claim, i.e., the ownership by ETFs increases the volatility of the underlying stocks. We know that this volatility is noise since sharp changes in flows at the ETF level causes price changes in underlying stocks, which tend to reverse after a few days.
I think that it is important for investors to understand the environment in which they invest and the prices that they invest in. Noisier prices means an added layer of volatility injected to the portfolio.
Here is how we determined the causal relationship in the data. We look at volatility of stocks around the threshold of being part of the Russell 1000 or Russell 2000 index. Stock number 1001 is the largest stocks in the Russell 2000, therefore ETF ownership is high. In contrast, stock number 1000 is the smallest stock in the Russell 1000, and therefore ETF ownership is low. We measure the difference in volatility between the two groups of stocks: those that are right below the threshold and those that are right above the threshold. We find that stocks that are above the threshold have high ETF ownership than those that are the threshold have low ETF ownership.
Where do you see the market evolving in ETFs? Is the market saturated? Any areas of product development that you’d like to see?
It seems that the academic research finally hits the regulators’ desks and that regulators appear to be concerned about the systematic and systemic effects that ETFs have on markets. My guess is that there will be some regulatory action on leveraged ETFs, where their rebalancing rattles the markets.
On the other hand, ETFs are still traders’ favorite instrument – they are traded in real time, are very liquid, and track all indices.
What do you see at the biggest upside to ETFs?
ETFs have definitely introduced new trading tools to the marketplace. They allow real time trading at low cost. It feels like you can take on any risk you want at a competitive price.
How about the biggest downside? Do you foresee any ETFs crisis?
The biggest concern is about the stability of ETFs during market stress. ETFs work great when they are well-priced, and they are well-priced because APs (authorized participants) and arbitrageurs close price differences between the ETF and the underlying securities. The issue is that during market stress, both APs and arbitrageurs tend to leave the market, creating even larger mispricings. It happened on August 24, 2015, and may happen again.
I love your illustration of liquidity shocks in ETFs (Figure 4). We tried to speak to ETF liquidity in this piece, but this is still a confusing topic for investors who are used to looking at “on screen liquidity” as actual liquidity. Do you have any ideas on how to better educate investors and make this aspect of ETFs easier to understand?
ETFs appear to be a double-edge sword for the liquidity of the underlying securities. On one hand, they provide liquidity because arbitrageurs (during normal market conditions) are quick to close any mispricings between ETFs and the underlying securities. So, a market price move is transmitted quickly to the underlying stocks.
On the other hand, ETFs crowd out liquidity from the securities to the ETF. This means that investors who use to trade the underlying securities directly in the past, prefer now to trade the ETF – it is cheaper and easier. This means that we lose liquidity at the stock level. One implication of this is that stock returns become less informative about companies’ financial prospects.
–Interview ends
Thanks for the insights, Zahi! We’ve got to learn a lot more about ETFs and we look forward to your future research.
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Article by Wesley R. Gray, Ph.D. – Alpha Architect
