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Prof. Semyon Malamud, SFI@EPFL, goes against consensus that the rise in the number of Exchange-Traded Funds in a market can lead to it drying up

Posted by
Anita Belitz Krasniqi
on
Monday, June 20, 2016 - 09:30

Prof. Semyon MalamudSFI@EPFL, was recently interviewed by l'AGEFI regarding the impact of passive investments on the economy. The rise of Exchange-Traded Funds (ETFs) has raised questions and concerns amongst scholars, economists and investment professionals about their impact on market risk and liquidity. Does the rise in these passive investments contribute to a drop in liquidity of a certain market?

Malamud points out that existing empirical studies of ETF liquidity often analyze the causal relationship or correlation between the liquidity of ETFs and the liquidity of the ETF's underlying basket of securities. What comes first - the ETF's liquidity or the basket's liquidity? Malamud has developed a model that doesn't try to answer the problem of the chicken or the egg but analyzes the interactions based on varying market conditions. His model, a modified version of the classical Capital Asset Pricing Model, suggests that there is an optimal number of ETFs that should not be surpassed for their impact to be positive on a market. Malamud's model suggests that, in most cases, that number should be less than half the number of existing securities.

Malamud's research finds that higher liquidity in the ETF primary market does not necessarily imply higher secondary market liquidity. In some cases, introducing new ETFs may lead to a reduction in volatility and co-movement for some assets. ETFs can play a positive role in that they allow for the distribution of risk and can better address the needs of investors. He says "The presence of ETFs modifies risk but doesn't necessarily amplify it".

This research is of prime importance for regulators and fund investors who should investigate the consequences of different ETF designs on the market.

The article can be downloaded here.

To read Prof. Malamud's research paper on the subject visit http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2662433