The Effect of Exchange-Traded Funds (ETFs) on Market Liquidity

Abstract

This study will establish the role of Exchange-Traded Funds (ETFs) in liquidity of the market by conducting a mixed-method research based on a detailed research methodology involving econometric modelling and qualitative analysis.   The metrics of liquidity performance results are the predetermined measures of bid-ask, illiquidity ratios, ten-year turnover ratios and effective spread, as presented by Amihud and Roll respectively.   The findings suggest that high-ETF ownership stocks are less illiquid, trading more and with a smaller spread than ETF-light assets, which shows conclusively that ETF trading greatly increases market liquidity.   The difference in differences computations are used to measure the validity of these improvements and the consistency of the results are verified by the robustness checks of the results with other liquidity measures.   The heterogeneous impact is revealed through sectoral analysis as the most liquidity gains are seen in the financial and technology sectors as compared to energy and utility sectors.   When comparing across countries, it can be identified that the high penetration of ETF in such markets as US and Japan is a highly liquidated market unlike emerging countries.  In addition, the possible hazards are also identified in the research.   Involving macroeconomic shocks and synthetic ETFs, when volatility spillovers are aggravated, then there is the concern of structural weaknesses and systemic vulnerability.   These findings are confirmed by the qualitative aspect as it is based on policy documents and regulatory reports.  It further highlights the reality that although ETFs are effective conduits of liquidity during a crisis, they may induce shocks on underlying stocks.   All said and done, this study concludes that ETFs provide access to new risk transfer opportunities and to a certain extent, more efficiently and liquidly trade.   This is of great interest to policymakers, regulators and investors who are struggling to reconcile measures taken to curb systemic instability and the advantages of ETF induced liquidity.