ETFs have become a popular way to trade broad sections of the market and avoid the excessive charges of a portfolio manager or mutual fund. The problem is that the tool that is supposed to make Stock trading easier and more profitable may have a side effect on volatility. Do ETFs increase stock volatility? Years ago we wrote about trading exchange traded funds.
The same skills of technical analysis that serve a stock trader are effective for trading exchange traded funds, ETFs. These investment vehicles track the composition of various collections of stocks. For example, an exchange traded fund may track the S&P 500 or the Russell 3000. Trading exchange traded funds is also possible with funds that track various market sectors such as bio tech or oil. The fundamentals that drive the US economy will commonly take the price of a widely based ETF up and down. Market sentiment drives daily price fluctuations. As such statistically based tools that predict market movement based on price patterns can be profitable. Profitable day trading strategies that work for any market commonly work for trading exchange traded funds.
Now there is evidence that ETFs increase volatility in stocks that they trade. The Fisher School of Business at Ohio State University asks Do ETFs Increase Volatility?
We study whether exchange traded funds (ETFs)-an asset of increasing importance-impact the volatility of their underlying stocks. Using identification strategies based on the mechanical variation in ETF ownership, we present evidence that stocks owned by ETFs exhibit significantly higher intraday and daily volatility. We estimate that an increase of one standard deviation in ETF ownership is associated with an increase of 16% in daily stock volatility. The driving channel appears to be arbitrage activity between ETFs and the underlying stocks. Consistent with this view, the effects are stronger for stocks with lower bid-ask spread and lending fees. Finally, the evidence that ETF ownership increases stock turnover suggests that ETF arbitrage adds a new layer of trading to the underlying securities
Does this increase in volatility improve or worsen your chances of making a profit by investing in an ETF
Look At The Underlying Stocks In Your ETF
Not all ETFs need necessarily be volatile. Morningstar writes about a defensive, low cost dividend growth ETF.
This dividend strategy has shone during market downturns by favoring companies with durable competitive advantages.
Vanguard Dividend Appreciation ETF (VIG) has several merits. The fund is backed by Vanguard’s massive indexing operation, which is topnotch in the industry. Like most Vanguard funds, it benefits from low fees. With an expense ratio of 0.10%, this exchange-traded fund is priced competitively relative to other strategic-beta offerings, which are typically a little pricier than standard index funds.
ETFs may indeed increase stock volatility but that may also depend on the ETF and on the purpose of that ETF. An ETF that targets high and reliable dividends is more likely to refrain from excessive trading than one that targets growth stocks or volatile sectors such as energy at the present time.
