ETFs have improved price efficiency between spot and futures markets – EDHEC

The introduction of exchange-traded funds (ETFs) has had a positive effect on the related futures market and/or underlying securities, according to an EDHEC-Risk Institute March 2012 publication.

Academic literature “suggests that the liquidity of the underlying index market increased after ETFs were introduced”, states the report. “Market responses to observed price deviations are also swifter in periods during which there is an ETF on an index than they are in periods before the existence of the ETF.”

Thirteen per cent of respondents from Edhec’s European ETF investor survey observed that ETFs had improved the price efficiency between spot and futures markets, and 21% observed improved liquidity in the underlying markets.

In a report, also released in March, Credit Suisse concluded that ETFs do not greatly influence single-stock trading. Despite the fact they have frequently been blamed for exacerbating market volatility and influencing single-stock returns, the Swiss bank’s analysis shows ETFs do not exert this influence “as much as one might be led to believe.

“There’s a misconception that every ETF trade… results in an equivalent wave of the underlying stocks being traded… our consultations and analysis have led us to believe that perhaps an average 15% of ETF trading actually results in trading in the underlying.”

A reason for this is that creation and redemption of ETF units, during which the underlying must be traded, is typically small in relation to capacity, says the bank. For example, for the iShares Russell 2000 ETF, net creation and redemption activity averages only 3% of underlying dollar volume.

In addition, arbitrage trading, one reason an investor may trade the underlying and ETF simultaneously (to exploit price discrepancies), is minimal.

“Our intraday study [1-minute increments] of various ETFs found they traded so efficiently that they were rarely at levels that would entice an arbitrageur to create/redeem and trade the underlying stocks,” says Credit Suisse.


This article was first published on Risk

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