Exchange-Traded Funds Ownership and Stock Volatility

Abstract

This study investigates whether exchange-traded funds (ETFs) increase the nonfundamental volatility of stocks in their baskets via the arbitrage channel. Since the price and the net asset value of the ETF underlying stocks are tied by arbitrage, liquidity shocks to the ETFs may propagate to the underlying stocks through arbitrage trading, which is called the liquidity trading hypothesis. We test the implications of this hypothesis using a sample of ETFs that track the KOSPI200 index. We address the potential endogenous relationship between ETF ownership and stock volatility using the KOSPI200 index reconstitution event as an instrumental variable in the two-stage least squares regression framework; we find the effect of ETF ownership on stock volatility is positive and significant. We also provide empirical evidence that foreign and domestic institutional investors exhibit more frequent trading in the opposite direction and higher-order imbalances for stocks with higher ETF ownership. In summary, our findings suggest that the growth of the ETFs in the Korean stock market may have had an unintended consequence of the higher volatility of ETFunderlying stocks.