A Case of ‘Wag the Dog’? ETFs and Stock-Level Liquidity

Exchange traded funds (ETFs) have become one of the most popular investment vehicles over the last two decades, with some ETFs now having more than twice the assets of the largest hedge funds. The trading activity of any large fund is expected to impact the price of the securities traded, but to what extent do ETFs impact the prices of their underlying securities? This research presents a model for estimating the sensitivity of security prices to ETF flows. The analyses show that the impact of ETF trading is transient, and of only a modest magnitude under even extreme assumptions. Inclusion of ETF flow sensitivity in a risk model produces improved risk-adjusted performance.

Highlights include:

• An ETF price impact model, which posits single-day impact of up to 370 bps / day on an individual security, and up to 250 bps / day on the index itself. Analyses indicate the effect is transitory and reverses over a period of 3-5 trading days. 
• The February 2018 market correction was accompanied by a $25B outflow of assets from ticker SPY, the SSGA S&P 500 Trust ETF. Modeling suggests that as much as one-third of the pullback was due to price pressure from ETF trading and that securities more sensitive to ETF flow underperformed.
• Sensitivity to ETF flow is used to build a risk model, which generates improved performance in a historical optimization. We offer a method for estimating ETF sensitivity for funds, using the S&P Global Ownership dataset.