ETF Arbitrage May Be Driving Market Volatility

In 2007, market volatility began increasing and experiencing serious spikes, shown by movements in the VIX. Also in 2007, the market saw large jumps in ETF issuance and trading volume. ETF net issuance in 2007 was $151 billion, versus $74 billion in 2006, according to the Investment Company Institute. Since 2007, movements in the VIX have been strongly correlated with changes in ETF trading volume. Also, the huge spike in volatility in 2008 was preceded by significant increases in ETF volume.

In Defense of ETF Arbitrage

Jim Rowley, Head of Vanguard ETF Data and Analytics, says volatility has always been in the market and is mainly a function of macroeconomic factors, not ETF trading. "ETFs are merely a reflection of investors looking at volatility in the market," he says. Instead of introducing more market risk, Rowley believes ETFs have been beneficial to market participants because "despite all the market turmoil, ETFs still offer broad diversification at low costs."

George Simon, former associate director of the Securities and Exchange Commission's Division of Market Regulation, says that "wildly fluctuating volatility is a structural problem," and increasing ETF volume has not necessarily led to increased market volatility. ETF trading has added volume to the market, but that does not mean volatility. Simon says that high frequency trading, such as with ETFs, should actually work to reduce volatility as trading occurs between the theoretical value and the market price of a security.

The Case Against ETF Arbitrage

However, Zahi Ben-David, a professor at the Fisher College of Business at Ohio State University, says "adding a new security to the market is a good thing, giving more options for investors, but it can also lead to unintended consequences." Ben-David, along with Francesco Franzoni and Rabih Moussawi, wrote "ETFs, Arbitrage, and Contagion", a research paper showing how ETF arbitrage can increase volatility and cause contagion in the market.

In the paper, Ben-David, Franzoni, and Rabih show how ETF arbitrage helps transfer liquidity or price shocks from the ETF to its underlying assets, even when the shock does not represent a change in fundamental value. These price shocks to the ETF cause more volatility in the underlying securities, as arbitrageurs cause the NAV to move "significantly in the same direction as the mispricing".