The growth of passively managed and exchange-traded funds (ETFs) has been a notable recent development in fund management. The assets held by ETFs have increased even more rapidly than those of the industry, and now account for more than 20% of the NYSE market capitalization (and about a third of its traded volume). This has been especially the case for funds investing in emerging markets. In parallel, the exposure of equity inflows to global risk has steadily increased over the past 15 years. More to the core of our argument, these two trends appear to be closely related. Is there a true causal connection between the two?
In a new paper (Converse et al. 2022), we find evidence that investor flows to ETFs are more responsive to global risk factors and less responsive to local factors such as the fiscal and growth performance, relative to investor flows to traditional mutual funds.
To argue this more rigorously, we proceed in two steps. First, we look at monthly fund-level data on investor flows to equity and bond mutual funds and ETFs (sourced from EPFR Global),2 and run a regression of these fund-level flows against one global factor (the St Louis Fed Financial Stress Index, a broad measure of global risk conditions) and one local factor (the median of growth in industrial production across the countries included in each fund’s scope), interacting these two factors with an ETF dummy to capture any differential sensitivity.3 We find that the negative relationship between global risk and investor flows is significantly larger (almost 1.5 times for equity and 1.25 times for bonds) for ETFs, compared to mutual funds investing in emerging markets.
Moreover, we analyze the potential mechanisms behind this excess sensitivity of investor flows to ETFs and show that ETFs with larger sensitivities to global risk factors are typically held more by investors that have a shorter trading horizon and trade more often in response to shocks.
In short, there is enough evidence to conjecture that in countries with a higher degree of ETFication, what is going on abroad may matter relatively more than what is happening at home. This is precisely where we take the second step of our analysis.
From investor behavior to country implications
In our country-level analysis, we estimate, for each country, a global sensitivity parameter β (the coefficient from a regression of (a) portfolio equity inflows from the balance of payments, and (b) stock market returns on our global risk factor), and we compare it with the country´s share of local equities held by ETFs (its period average). Figure 2 shows the result: capital flows are closely driven by global shocks (β is more negative) the larger is the ETF share.
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.
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.
