Geopolitical risk effects on the quality of exchange-traded funds in developed and emerging markets.

Abstract

Exchange-Traded Funds (ETFs) have gained popularity as the demand for low-cost and easily accessible investment vehicles. However, ETFs may be significantly influenced by Geopolitical Risks (GPR). GPR plays an important role in shaping market quality by affecting returns, volatility, and liquidity in both emerging and developed markets, and often lead to heightened uncertainty and market disruptions. Although several studies in the literature have examined the GPR effect on ETF returns, volatility, or liquidity individually, studies that jointly examine the GPR effect on ETF market quality remain scarce. Therefore, this study examines the GPR effect on the quality of ETFs in developed and emerging markets. To achieve the objective of this research, the study makes use of fourteen ETFs that track broad market indices, comprising of seven ETFs from emerging markets and seven from developed markets, and trade in their respective home countries. The sample period spans from each ETF inception date up to 31 December 2024. This study employs a Markov Regime-Switching model to examine the effect of GPR on ETF returns, a GARCH-MIDAS model to examine the effect of GPR on ETF volatility, and NARDL model to investigate the effect of GPR on ETF liquidity. The findings from this study show that GPR has limited effect on ETF returns, with global GPR exhibiting little direct effect, while country-specific GPR shows stronger and more persistent effects on returns, particularly in developed markets. GPR significantly affects ETF volatility, with emerging market ETFs exhibiting greater sensitivity to global GPR, while developed market ETFs show higher volatility persistence following geopolitical shocks. In addition, GPR affects ETF liquidity asymmetrically, with ETFs from emerging markets exhibiting stronger and more unstable long-run and short-run liquidity responses to both global and country-specific GPR, while ETFs from developed markets display muted and stable liquidity reactions. These findings indicate that investors should not assume that holding ETFs from different asset classes will automatically spread-out risk. As a result, investors may need to take proactive adjustments during periods of elevated GPR. Policy makers should ensure market stability because emerging markets are highly volatile and rapidly lose liquidity during geopolitical shocks.