Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets

Exchange traded funds (ETFs) have a novel design that allows them to “open up” illiquid markets hitherto resistant to index products. We demonstrate that such ETFs also have the potential to alter the informational efficiency of underlying markets and introduce fragility via herding. Specifically, while these ETFs bring more information to the markets at the aggregate level, individual asset prices may face persistent dislocations. We also show that such ETFs can exacerbate herding, where speculators across markets trade similarly, unhinged from fundamental value. All results arise from the distinct characteristics of inter-market learning in ETFs on hard-to-access underlying settings