Passive funds affect prices: evidence from the most ETF-dominated asset classes

Summary

Focus

This paper studies the size and source of exchange-traded funds' (ETFs) price impact in the most ETF-dominated asset classes: volatility (VIX) and commodities. These ETFs hold a much larger share of the underlying market compared with equities or bonds. The fraction of ETFs in the market for VIX futures often exceeds 40%, whereas it is less than 2% in the S&P 500 Index. Several episodes from the VIX market in 2018 and the oil market in 2020 showed that large ETF-induced trading can exacerbate price changes in turbulent times. To understand the risks of trading against ETFs, I propose a novel decomposition of ETF demand into three major components: calendar rebalancing, flow rebalancing and leverage rebalancing.

Contribution

The existing ETF literature has focused almost exclusively on equity markets, where fundamental values are difficult to measure. I use the beneficial setting of the futures market, where non-fundamental price distortions are easier to quantify. Without making any assumptions, I directly test whether the ETF-influenced futures price is informative about the fundamental cash flow (spot price) at expiration. The institutional features of VIX and commodity ETFs allow me also to study the price impact of leverage-induced trading.

Findings

First, ETFs put pressure on the prices of underlying assets in VIX and commodity markets. Second, ETF price impact is not related to price discovery but manifests itself through an increase in the non-fundamental part of prices. To identify ETF-induced price distortions, I propose a model-independent approach for replicating the fundamental value of a VIX futures contract. I use the definition of variance and construct a synthetic futures contract that is not influenced by ETFs. This allows me to isolate a non-fundamental price gap of 0.61 volatility points (113% of the first-month futures basis). A simple strategy of trading VIX futures based on the sign of the EFG delivers a Sharpe ratio of 1.78. Third, leverage rebalancing has the largest impact on non-fundamental price deviations. This type of ETF demand amplifies price changes and introduces unhedgeable risks for ETF counterparties, exposing them negatively to variance.

Abstract

This paper studies exchange-traded funds' (ETFs) price impact in the most ETF dominated asset classes: volatility (VIX) and commodities. I propose a model-independent approach to replicate the VIX futures contract. This allows me to isolate a non-fundamental component in VIX futures prices that is strongly related to the rebalancing of ETFs. To understand the source of that component, I decompose trading demand from ETFs into three parts: leverage rebalancing, calendar rebalancing, and flow rebalancing. Leverage rebalancing has the largest effects. It amplifies price changes and exposes ETF counterparties negatively to variance.

JEL classification: G11, G13, G23

Keywords: ETF, leverage, commoditization, VIX, futures