Skip to Content

News & Perspectives

Trading Strategies & Market Analytics

5 Reasons ETFs impact stocks less than you think

by Phil Mackintosh

Crib Sheet

ETFs trade almost $80bn each day, making up around 29% of all stock trading by value. Because of this, ETFs get blamed for contributing to volatility and correlation (among other things).

We highlight five reasons these fears are overblown:

  1. The VIX is near all-time lows, and correlations have broken down since the election, despite a surge in ETF trading.
  2. Futures trade more than $250bn/day concentrated in two beta exposures and have a far greater effect than ETF trading.
  3. Creations and redemptions are much smaller than ETF volumes, averaging just $8.9bn/day, or 11% of all ETF value traded.
  4. Less than 10% of ETFs trigger stock arbitrage during the day.
  5. ETF baskets are liquid. Even a $1bn trade in small or mid-cap ETF represents less than 10% of ADV in the underlyings.

ETFs impact stocks less than you think

ETFs trade almost $80bn each day, making up around 29% of all stock trading by value. Because of this, ETFs get blamed for contributing to volatility and correlation, as well as making it harder to trade underlying stocks.

We highlight five reasons these fears are overblown.

1. Futures are way bigger and more correlated.

US Equity Futures trade over $250bn/day, more than 3x the value of ETFs and much more than underlying stocks. Futures liquidity is also concentrated in just two vanilla portfolios: S&P500 and Russell 2000. Intuitively, futures trading should contribute far more to volatility, especially correlation.

In contrast, the $79bn/day of ETF trading is spread across sectors, countries, and asset classes (Exhibit 2). In fact, we would argue that as ETFs offer more granular portfolios, they are net contributing to stock selection at a sector and style level.

2. VIX is low and correlations have broken down.

Since the election, we have seen a surge in ETF trading as hedge funds and other investors rushed to reposition portfolios.

Despite this, the VIX has been near all-time lows (around 11 as we write), and correlations have broken down significantly since the election.

3. Creations and redemptions average just $8.9bn.

Although ETFs trade around $79bn/day, creations and redemptions average just $8.9bn/day. That’s just 11% of all ETF value traded, and we think a better measure of how much ETFs really impact stocks.

4. Stock-arb happens less than 10% of the time.

Most liquid ETFs have spreads that are tighter than their underlying basket. Moreover, we’ve shown that most ETFs trade inside the underlying spreads, making stock arbitrage uneconomical.

In fact, we estimate that less than 10% of all ETF trades would trigger stock arbitrage (Exhibit 3), roughly the same proportion as the observed creation ratio (above).

5. Baskets are much more liquid than ETFs.

That still leaves around 10% of ETF trades that are big enough to cause underlying trading. What about them?

The first thing we’d highlight is that underlying stocks are almost always much more liquid. For example, a $1bn trade in relatively illiquid markets is usually still digestible:

  • Just 10% of ADV in underlying small or mid-cap US stocks
  • 5% of the underlying in corporate bonds
  • Around 10% of daily value traded in emerging markets

Huge trades do impact underlyings

Of course, some trades do affect stocks, sometimes very publicly.

Mostly these are very large trades, where some market impact is unavoidable whether the portfolio rebalancing is done with ETFs or “old-fashioned” stock trades.

What’s important with large trades is to execute them carefully. Trading too aggressively or signaling to the market adds unnecessary costs. That’s one reason we recommend clients talk to our ETF desk before trading an illiquid ETF or a very large notional.

Many people worry about bond market liquidity, and still more worry that ETFs might trigger a crash in the bond market because of the lack of underlying liquidity.

Back in April 2016, we saw HYG redemptions totaling almost $3bn. Here is what happened:

Remember that the underlying liquidity in all corporates is just $20bn.

So, a $3bn trade is large in proportion to the underlying high yield liquidity.

Sensibly, the trade was spread over three days, which helps minimize market impact.

The morning of April 29 there was spike in trading volume (green bars, lower chart) that caused the ETF to sell off to as much as a 72bps discount to NAV (blue vs green line).

Slowing down in the afternoon helped HYG’s price recover

 

Because bonds are illiquid and not exchange traded, their NAVs slow to mark-to-market. Overnight, the NAV for HYG closed at 83.16, a discount to the intraday NAV and even the HYG close.

 

Disclaimer

This material is not research and is not intended as such. It has been produced by personnel employed within the Trading Strategy Department and/or by Sales and Trading personnel of KCG Americas LLC (“KCGA”). This material is intended only for clients of KCG Holdings, Inc. and its subsidiaries (collectively “KCG”). It is not intended for further dissemination in its present form or any other and may not be further disseminated beyond the initial recipient without express consent from KCG. This material is not intended to constitute an offer, or solicitation of an offer, to purchase or sell any security or financial instruments or to participate in any investment strategy. The securities and strategies referenced in this material are not intended as recommendations and may not be suitable for you. KCGA believes that the information contained herein is accurate but does not warrant that is accurate, complete or up to date. The views expressed herein are based on assumptions. Any of those assumptions may be incorrect. KCG does not guarantee the performance or success of any opinion or idea expressed in the information. KCG assumes no liability to anyone as a result of the use of this material. This material provides the observations and views of the persons who prepared the material. These observations and views may be different from, or inconsistent with, the views of KCG or other Departments or persons within KCG. The observations and views expressed in this material may change at any time without notice. KCGA makes markets and trades for its own account and may hold positions in any of the securities of the issuers referred to herein or in related financial instruments. The persons who prepared this material may also advise our trading desks.

In the US, products and services are offered by KCGA, member FINRA/SIPC. In Europe, products and services are offered by KCG Europe Limited (“KCGEL”) which is authorized and regulated by the FCA. KCGA and KCGEL are affiliates and are indirect subsidiaries of KCG. For additional information about KCG (NYSE: Euronext: KCG) please visit http://www.kcg.com

© 2017 KCG Holdings, Inc. All rights reserved.