Examining this link more closely, we find that where ETFs hold a larger share of a country’s equity market capitalization, both portfolio inflows and aggregate stock market prices are more sensitive to global risk.4 A one standard-deviation increase in the share of equity held by ETFs is associated with an exposure to global risk that is 2.5 times higher for portfolio equity inflows. For stock market prices, a similar increase is associated with an exposure to global factors that is almost 1.4 times larger.
Of course, many other variables may cause both a larger exposure to global financial stress and a higher ETF share at the country level. We address these potential concerns in three ways to strengthen our interpretation of the results:
- We include a host 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 significant when interacted with the global risk factor.
- We use a change in Vanguard’s funds and ETFs from the MSCI index to the FTSE index (due to the lower cost of the latter) to identify changes in ETF and mutual fund shares that are less related to specific country conditions. We show that changes in ETF shares (unlike those in mutual fund shares) due to this exogenous event are indeed related to a higher exposure to global financial stress.
- We link our fund- and country-level estimations and show that the dollar flow sensitivities to ETFs relative to that of mutual funds from both estimations are similar.
Overall, these findings support the intuition that , in line with the “benchmark effect” introduced in Levy-Yeyati and Williams (2012) and Raddatz et al. (2017).
These results, combined with the still growing popularity of ETFs around the world, raise challenges for emerging market policy makers 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.
References
Converse, N, E Levy-Yeyati, and T Williams (2022), “How ETFs Amplify the Global Financial Cycle in Emerging Markets,” forthcoming in Review of Financial Studies.
Levy-Yeyati, E, and T Williams (2012), “Emerging Economies in the 2000s: Real Decoupling and Financial Recoupling,” Journal of International Money and Finance 31(8): 2102–2126.
Raddatz, C, S Schmukler, and T Williams (2017), “International Asset Allocation and Capital Flows: The Benchmark Effect,” Journal of International Economics 108: 413-430.
Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” Federal Reserve Bank of Kansas City Economic Policy Symposium.
1 Passive management of mutual or exchange-traded funds (ETFs) refers to the case in which the fund’s portfolio mirrors a market benchmark, typically an index or combination of indexes such as the S&P500 or the EMBIG, as opposed to active management that attempts to beat the benchmark through idiosyncratic investment strategies.
2 The period is January 1997 to August 2017 for equities, and from January 2002 to August 2017 for bonds. EPFR data provides good representative coverage of the fund universe: as of mid-2017, they accounted for roughly 66% of total worldwide mutual fund and ETF assets.
3 The results are robust to the use of alternative global and local risk factors.
4 More specifically, we estimated a regression of gross equity liability flows from the balance of payments or the MSCI country returns on our global risk factor and an interaction of the global risk factor with the lagged share of local equities held by ETFs.
