The flood of money investors are putting in ETFs is distorting stock prices and worsening volatility, study says

• The ETF boom is making the stock market a lot more jittery and distorting prices, according a recent study.
• Increasing ownership of passive ETFs has widened a stock's bid-ask spread and its volatility.
• The "increase in passive ETF ownership may warrant a closer examination of its effects on market dynamics."

Critics of passive investing got fresh ammunition with a recent study that found the boom in exchange traded funds has warped the stock market by distorting prices and increasing volatility.

The latest round of the ETF debate was highlighted by Bloomberg and comes as Wall Street looks back on the life of Charlie Munger, who famously preached index funds for most investors.

"Higher passive ETF ownership reduces the importance of firm-specific information for returns but increases the importance of transitory noise and a firm's exposure to market-wide sentiment shocks," researchers at Goethe University in Germany wrote in the study published last month.

Which is to say that as money has flooded into ETFs, it's made information like a firm's earnings or product launches less important for stock prices than bullish trends or other "noise." That decreases liquidity in the market because of the way ETFs are designed.

ETFs have become popular because they're cheaper and allow investors to put their money in a basket of stocks, but the Geothe University researchers bolstered the claims of the anti-ETF camp.

Taking 872 passive ETFs and looking at performance data spanning June 1997 to December 2021, Philipp Höfler, Christian Schlag, and Maik Schmeling found that higher passive ownership increases a stock's bid-ask spread, volatility, exposure liquidity shocks, and tail risk.

Also, they found that variations in passive ETF ownership were associated with higher risks of sharp price swings.

"This finding suggests that changes in [passive ownership] do indeed affect asset price dynamics beyond simple return volatility and that (option) markets price the effects of changes in passive ETF ownership," they said.

This is not great for the markets, researchers warned, because it's making it a whole lot more jittery.

The debate around passive ETFs has been going on for a while. Like Munger, Warren Buffett also has long championed low-cost index funds.

On the other side, there are those like analysts at Sanford C. Bernstein & Co., who once called the investing style "worse than Marxism."

But according to Bloomberg Intelligence, index funds and ETFs don't own enough of the equity market to pose a systemic threat. About 8% to 9% of an average stock's shares outstanding are owned by ETFs. 

But the size of the ETF market is expected to balloon to 24% of all fund assets by 2027, according to Oliver Wyman. And the Geothe University researchers pointed out that the cons of the booming ETFs may outweigh the pros.

"The rise of passive investing and the associated increase in passive ETF ownership may warrant a closer examination of its effects on market dynamics," they wrote. "Policymakers should consider the potential trade-offs between the benefits of lower transaction costs and the potential costs of reduced price efficiency and market-making capacity."

Read the original article on Business Insider