Are Passive Exchange-Traded Funds a Catalyst for Market Instability?

Abstract

Exchange-traded funds (ETFs) figure prominently as a notable outcome of financial innovation, offering a cost-efficient avenue for acquiring a diversified portfolio and enabling frequent trading. However, the significant expansion of the ETF market has raised concerns among investors and regulators. The heightened liquidity and passive characteristics of indexed ETFs have the potential to lead to synchronized movements in stock prices and noise trading, thereby impacting underlying securities through arbitrage. This research examines the influence of the escalating ownership of passive ETFs on US stocks and its potential to destabilize the market. Utilizing the constituents of the S&P 500 index, our findings supported the pivotal role of passive ETF ownership in shaping price volatility and systematic risk. Moreover, the study reveals compelling evidence suggesting that issuer concentration in the underlying index may act as an additional factor contributing to systematic risk