ETF ownership and stock liquidity: evidence from China

ABSTRACT

Due to their low participation cost, exchange-traded funds (ETFs) are booming in China. We find that stocks with higher ETF ownership display higher liquidity while controlling for other institutional ownership. In the post-crash periods when ETF market evolves rapidly, the impact becomes greater. For large-capitalization stocks, ETF ownership has a stronger impact on stock liquidity. The liquidity shocks in the ETFs market can propagate to the underlying stocks through the instantaneous creation/redemption arbitrage mechanism. Moreover, ETF market makers create/redeem to manage their inventory risk, therefore introducing liquidity to stocks.

KEYWORDS:

• ETF ownership
• stock liquidity
• instantaneous arbitrage
• market maker
• primary market

JEL CLASSIFICATION:

• G11
• G23

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary data

Supplemental data for this article can be accessed online at https://doi.org/10.1080/16081625.2024.2346581

Notes

1. We use the ‘market maker’ and ‘liquidity provider’ interchangeably later in the article.

2. The current estimates regarding ETF ownership are available at Wind, and the missing data can be supplemented by CSMAR’s institutional holdings data and data calculations from quarterly reports. Although ETFs are created/redeemed on a daily basis and the total number of ETFs shares outstanding changes on a daily basis, we are limited by the availability of data and use quarter-end data for our calculations. We apply the same method to construct the Index Ownership of index funds and Active Ownership of active funds.

3. The selection of control variables refers to Ben-David, Francesco, and Moussawi (2018) and Agarwal et al. (2021). We do not include time-series variables like macroeconomic policy uncertainty. In each of our models, the quarterly time fixed effect is added to the panel regression of quarterly data. For variables like macroeconomic policy uncertainty, which is only related to time, they will be absorbed by quarterly fixed effects.

4. We choose this instrumental variable because: (1) Correlation condition is satisfied. The average characteristics of other individuals in the group will affect the characteristics of individuals. (2) Exogenous condition is satisfied. The average characteristics of other individuals in the group do not directly affect the results of individuals. Although Gormley and Matsa (2014) criticized such instrumental variables, it can be seen from the author’s original text that for the management research is not suitable to use this kind of instrumental variable, because the industry has a strong fixed effect on the dependent variable (productivity profit rate). The dependent variable, stock liquidity, in this paper does not have such a problem.

5. We take logarithms of the values for two reasons: first, the magnitude of creations and redemptions is too large compared to other variables, and second, to circumvent possible heteroskedasticity problems.

6. There are two reasons for the increase in the number of the creation/redemption: an increase in frequency or an increase in the amount of a single creation/redemption. In fact, a better measure of ETF arbitrage activity is the real-time difference between price and IOPV (as a signal variable for arbitrage initiation). Based on data availability, we only use the process variable: creation and redemption.

7. The exchange approves the qualification of ETF market makers and publishes the list of ETF market makers on a daily basis (Shenzhen Stock Exchange: http://fund.szse.cn/marketdata/asp/index.html, Shanghai Stock Exchange: http://etf.sse.com.cn/marketer/). Exchanges may conduct supervisory checks on the risk management of market makers, and position management is the most important part of market maker risk management. A more intuitive indicator to measure the market maker’s position management is to calculate the number of the creation/redemption made by the market makers when the unilateral position exceeds the minimum creation/redemption unit through the market maker’s position details. Based on data availability, we measure this activity using only the number of market makers.

Additional information

Funding

This work was supported by Beijing Postdoctoral Research Foundation (2023-ZZ-185).