Can ETFs affect U.S. financial stability? A quantile cointegration analysis

Abstract

This study evaluates whether exchange traded funds (ETFs) threaten financial market stability by testing two hypotheses relating the growing importance of ETFs to increased market volatility and rising equity valuations. We estimate quantile cointegration models using Standard & Poor's 500 Index (S&P 500) and Chicago Board Options Exchange volatility Index (VIX) data for 1994–2020. We found that an increase in ETFs is positively and significantly related to the long-term valuation of the S&P 500 for quantile values above the median. By contrast, ETFs have only a negative and significant effect on the VIX for quantiles around the median. Ultimately, two novel results were obtained. First, the distortion in the value of the S&P 500 relative to its fundamentals is driven by investor flow into ETFs during a bull market. Second, the impact of equity ETFs on the VIX is only affected when fundamental factors are in play, decreasing it. Therefore, ETFs contribute to forming equity bubbles and support valuation market dynamics. Both regulators and policymakers should consider these conclusions.