Exchange traded funds, market volatility and market efficiency

Submission note: A thesis submitted in total fulfilment of the requirements for the degree of Doctor of Philosophy to the La Trobe Business School, La Trobe University, Bundoora.

This thesis contributes to the literature by comprehensively exploring the connections between index-tracking Exchange Traded Funds (ETFs) and their underlying index. Its main part consists of three essays focusing on S[and]P 500 index. The first essay studies the relation between S[and]P 500 volatility and ETF trading activities using OLS, GARCH and VAR approaches. Results of OLS and GARCH estimations suggest that the contemporaneous ETF trading is a prime contributor to index volatility. VAR estimation not only shows a significant effect of lagged ETF trading on index volatility but also presents a two-way Granger causality between the two variables. The second essay sheds insights on the relation between ETF trading and index price efficiency, and the price discovery process of the index and its ETFs. There is solid evidence showing that both contemporaneous and lagged ETF trading activities are crucial contributors to the price efficiency of the underlying index, while this efficiency impact by ETF trading is weakened by ETF creation/redemption. Moreover, the synthetic ETF price dominates the index in information share and the dominance increases in ETF trading. However, the relation between an individual ETF’s information share and its trading volume varies, depending on the size of the ETF. The last essay analyzes the relation between information-based ETF trading and the volatility of the underlying index. It first decomposes ETF trading by the novel HMM approach of Yin and Zhao (2014), and then explores the effect of each type of ETF trading on S[and]P 500 volatility. It demonstrates that the ETF trading stemming from investors’ disagreement is a leading determinant of index volatility. However, privately-informed ETF trading shows no significant impact on S[and]P 500 volatility while liquidity ETF trading can partially explain the volatility. Moreover, these trading components of the leading ETF have more profound effects than smaller ETFs.