Exchange Traded Funds, Liquidity, and Market Volatility

Abstract

Given the exponential growth in ETF trading over the past decade, we consider the proposition that trading in ETFs transmits volatility to their largest component stocks and thus to the stock market in general. We find empirical support for this proposition, since volatility spillovers from ETFs to component stocks are significant, as well as increasing in liquidity and the proportion of each stock held by the fund. The results are consistent with a positive volume-volatility relation and trading-based explanations of volatility, and are relevant to market participants and regulators, since ETFs may contribute to stock market volatility via arbitrage activity and the impounding of non-fundamental information.