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ETFs: new golden eggs for investors or a hype?

15 March 2022
Investing in exchange-traded funds (ETFs) is becoming increasingly popular. Unlike traditional mutual funds, with ETFs you have a greater chance of getting better returns at a low cost and with a wide diversification. Nevertheless, caution is advised, says financial researcher Egle Karmaziene (VU Amsterdam), because despite the increasing popularity, financial experts not fully understand how ETF trading affects the underlying securities.

What are ETFs exactly? ETFs are best described as stocks or bonds that are bundled together in a basket and track the underlying value of a particular stock market index. Despite having lower risks than underlying securities, they still hold two types of risks: systematic risk (a risk that can simultaneously affect multiple assets) and idiosyncratic risk (a risk that affects only a stock or bond of the a particular company).

Primary and Secondary Markets
Most economists focus on the effect of ETF primary market trading on the underlying securities. Karmaziene highlights the importance of the secondary market trading, since “currently over 80% of transactions occur in the secondary market and this fraction is increasing over time. For an investor, the secondary market is therefore the most interesting place to trade in. Yet we know little about how this type of trading impacts the assets.”

Reason enough for Karmaziene to dive into the world of ETFs together with her American colleague Caitlin D.Dannhauser (Villanova University).

Academics predict that by trading in ETFs together, returns of underlying securities start going up together and going down together. The returns tend to co-move or have larger systematic risk, which investors despise. According to Karmaziene and Dannhauser, this claim is incorrect in the bond market. In fact, being a part of a frequently-traded ETF improves the way information is incorporated in the asset price.

Karmaziene: “Our research focuses on bond ETFs, which are so important for the small provide individuals. It provides them an access to the illiquid and hardly accessible bond market. Its common minimum investment of $100,000 deters many potential investors.

In any case, the VU researcher hopes that her study will contribute to policy-makers’ willingness to understand the broader effect of the tremendous growth of bond ETFs and their accelerated trading activity.

Read the research paper The Two Sides of the Coroporate Bond ETF Liquidity Transformation by Egle Karmaziene and Caitlin D. Dannhauser.