The growth of passively managed and exchange-traded funds (ETFs) has been a notable recent development in fund management. ETF assets have grown faster than the industry’s and currently account for almost 20% of NYSE market capitalization. (and about a third of its traded volume). 1 This is true for emerging market funds (figure 1). There has been a global risk exposure to equity inflows for 15 years. These two patterns are important to our argument. Is there a causal link?
Figure 1: The share of the ETF market and the exposure of emerging markets to a global financial shock.
To prove this, we use two steps. First, we look at monthly fund-level data on investor flows to equity and bond mutual funds and ETFs (from EPFR Global2) and run a regression of these fund-level flows against one global factor (the St Louis Fed Financial Stress Index, a broad measure of global risk conditions) and one local factor (the median of industrial production growth across the countries included in each fund’s scope), interacting. these two factors with an ETF dummy to capture any differences. 3 We demonstrate that the negative association between global risk and investor flows is 1.5 times stronger for ETFs than for emerging market mutual funds.
Moreover, we explore the probable processes behind this excess sensitivity of investor flows to ETFs and show that ETFs with bigger sensitivities to global risk or the spread of financial risk around the world variables are held more by investors with a shorter trading horizon who trade more often in reaction to shocks.
In countries with more ETFication, what happens outside may matter more than what happens at home. This is the second step of our analysis.
Investing in country implications or financial Risk
In our country-level research, we construct a global sensitivity parameter (the coefficient from a regression of portfolio equity inflows from the balance of payments and stock market returns on our global risk factor) and compare it with the country’s share of local shares held by ETFs (its period average). Figure 2 depicts the outcome. The bigger the ETF share, the more global shocks drive capital movements.
Figure 2: Country betas and ETF market capitalization
When ETFs control a country’s equity market capitalization, portfolio inflows and stock prices are more exposed to global risk. 4 A one standard deviation increase in ETF equity exposure increases portfolio equity inflows by 2.5 times.
Many other reasons can increase global financial stress and the country’s ETF share. Three techniques help us interpret the results:
- We include a number of control variables related to financial integration, such as the share of local equities held by traditional mutual funds and the external liabilities at the country level. We find that only the ETF share is important when the global risk factor is taken into account.
- We use a change in Vanguard’s funds and ETFs from the MSCI index to the FTSE index (because the FTSE index is cheaper) to find changes in ETF and mutual fund shares that are less tied to specific country conditions. We show that changes in ETF shares, which are not the same as changes in mutual fund shares, because of this outside event are linked to a higher risk of global financial stress.
- We connect our fund-level and country-level estimates and show that the dollar flow sensitivity of ETFs compared to that of mutual funds is the same in both estimates.
These results, combined with the still growing popularity of ETFs around the world, raise challenges for emerging market policymakers to the extent that they deepen the “dilemma not trilemma” concerns for small, open economies that are open to cross-border flows (Rey 2013). More precisely, in the presence of a global financial cycle that hampers the effectiveness of domestic monetary policy in emerging markets, these restrictions could be further amplified by the penetration of ETFs, strengthening the case for mitigating capital controls or macro-prudential policies.
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