The Impact of Flows into Exchange-Traded Funds: Volumes and Correlations

Abstract

There is a common perception that the recent growth in passive index investing through exchange-traded funds (ETFs) has had detrimental effects on the market quality of the underlying basket securities. In particular, there is concern that ETF trading substitutes for and takes away from liquidity in the underlying securities and increases the co-movement in their returns. In turn, it is argued that increased pairwise correlation among stocks impairs price discovery and the ability of active managers to generate alpha. In this article, the authors find no evidence to support these perceptions. Volume changes in ETFs and their underlying securities are positively, not negatively, correlated. Furthermore, this research indicates that the rise in cross-stock correlations is due to the macro environment, not ETF growth.