Friday, March 8, 2013

The Dark Side of ETF Investing: A World-wide Analysis

Read the working paper
INSEAD Working Paper 2013/39/FIN

We study conflicts of interest in the exchange-traded fund (ETF) industry around the world. We provide evidence that ETFs provide cheap funding resources to benefit the other members of the financial groups to which they belong. We identify three channels via which this happens. First, the ETF’s assets are used by the affiliated bank to leverage its (lendingrelated)information. Second, ETFs subsidize affiliated banks when the latter are in need, i.e., unprofitable or poorly rated. Third, the ETFs help affiliated OEFs through cross-trading, that is, they load up on unnecessary (to track the benchmark) volatility that will expose them in the event that the affiliated bank becomes distressed. The effects prevail in ETFs that do not fully replicate their benchmark holdings and that domiciled in Europe. Market awareness of this risk is reflected in reduced flows and a lower ETF price premium. These results have important normative implications for both consumer protection and financial stability.