Do ETFs Increase Volatility?

Abstract

Due to their exceptional liquidity, ETFs are likely to be a catalyst for noise traders. This noise can propagate to the underlying securities through the arbitrage channel. Therefore, we explore whether ETFs increase the non-fundamental volatility of the securities in their baskets. We exploit exogenous changes in index membership, and find that stocks with higher ETF ownership display significantly higher volatility. ETF ownership is also related to significant departures of stock prices from a random walk at the intraday and daily frequencies. Additional time-series evidence suggests that ETFs introduce new noise into the market, as opposed to just reshuffling existing noise across securities.