Do ETFs affect the return co-movement of their underlying assets? Evidence from an emerging market

Abstract

Purpose The objective of the present study is to examine how domestic and foreign exchange traded funds (ETFs) tracking Indian equities affect the return correlations of their underlying constituents. Further, this study investigates how these effects vary between periods of turmoil and calmness in the financial markets.Design/methodology/approach The study is based on quarterly data for stocks comprising the CNX (CRISIL NSE Indices) Nifty 50 Index from 2009Q1 to 2019Q4. The data on holdings of 45 domestic and 196 foreign ETFs in the sample stocks were obtained from Thomson Reuters’ Eikon. The paper employs a panel-regression methodology with stock and time fixed effects and robust standard errors.Findings This study documents that irrespective of the market conditions, foreign ETFs, particularly those from Asia–Pacific and European regions tend to exacerbate co-movement. Conversely, domestic ETFs lower co-movement in stable markets but during periods of turbulence a jump in return correlations is observed.Practical implications The results have important implications for ETF investors as well as market regulators because an increase in co-movement would reduce the diversification benefits of ETFs, thereby nullifying the biggest advantage that ETFs have to offer.Originality/valueThe literature on the economic impact of ETFs is highly skewed with the majority of the studies focusing on developed markets. To the best of the authors’ knowledge, this study is the first one to empirically examine the impact of ETFs on the return co-movement of an emerging market. Furthermore, the study is unique as the authors investigate how the effects of ETFs vary in turbulent and tranquil markets.

Can ETFs mitigate stock Co-movement? An analysis of an emerging market

“…Additionally, the creation and redemption process may require the purchase or sale of large quantities of underlying assets, leading to market imbalances and price volatility. These results align with the previous investigations by Da and Shive [ 8 ] and Jhunjhunwala and Sethi [ 28 ].…”

“…This measure is used to understand the degree of stock co-movement and exposure to systematic risk, with a higher value indicating a greater degree of co-movement with the market. Conversely, a lower value indicates a lower degree of co-movement with the market, with specific risk playing a more significant role in total stock risk [ 8 , 28 ]. Lastly, the Sync metric is employed to illustrate the degree to which variations in returns of stock are explained by returns of market.…”

“…Nonetheless, Glosten et al [ 27 ] contended that ETFs disseminate macroeconomic fundamental information to the stock market via arbitrage trades, resulting in a rise in market interdependence. Jhunjhunwala and Sethi's [ 28 ] research verified that the intensification of the ETFs' market interdependence effect occurs solely during turbulent market phases. Marta and Riva [ 29 ] found that ETFs increase the movement of their component stocks.…”

Examination of Leverage effect among India and Global GOLD Exchange Traded Funds

“…This study investigates the amplitude and direction of the movement of information between the spot and futures indices. (Jhunjhunwala & Sethi, 2022) This study documents that irrespective of the market conditions, foreign ETFs, particularly those from Asia-Pacific and European regions, tend to exacerbate co-movement. The current research examines how domestic and foreign exchange-traded funds (ETFs) tracking Indian equities affect the return correlations of their underlying constituents (Vardar & Aydogan, 2019) The empirical results reveal the existence of positive unilateral return spillovers from the bond market to the Bitcoin market.…”