The rapid expansion of the ETF universe could be affecting the availability of company shares and affecting stock price swings.

“Investors assume that the S&P 500 [the main US equity market benchmark]is a super liquid universe but growth in the shares held by ETFs and other index fund managers has reduced the availability of stocks for trading for other market participants,” Savita Subramanian, head of US equity and quantitative strategy at Bank of America Merrill Lynch, said, the Financial Times reports.

“Stocks that are more widely held by ETFs and passive mutual funds display systematically higher volatility than the stocks that are less widely held by those same funds,” Subramanian added.

ETFs are largely passive index-based funds that help investors track broad or niche areas of the market. The investment vehicle accomplishes this goal by tracking a underlying index comprised of various company stocks. In the case of an S&P 500 ETF, one share of the ETF would represent a basket of S&P 500 company stocks.

ETFs have gathered $3.5 trillion in net inflows over the past decade, and now regularly make up a third of all trading on the U.S. stock market and take up an even larger share in periods of heightened volatility. However, the overall U.S. liquidity has been on a downward trend since the financial crisis.

In addition, Michael Steliaros, global head of quantitative execution at Goldman Sachs, believed that the rise of passive ETFs and index-tracking funds influences the dynamics of individual stocks, which affects the ways investors build and manage portfolios.

A Goldman analysis revealed the relationship between passive ownership and stock volatility in both the U.S. and Europe typically grows stronger latter in the trading day and peaks in the hours before the close, as well as the auction itself, when the final price is determined. This is an especially important period since stocks held by an ETF are traded to rebalance or accommodate new cash inflows at the close, which can contribute to price volatility.

“It is important to understand how the effect of passive ownership of stocks works — it has significant implications for when a trading desk might choose to execute a transaction,” Steliaros told FT.

For more information on the markets, visit our current affairs category.

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