The impact of exchange traded funds on the microstructure of their constituent shares: a South African case.

Abstract

The creation of the Exchange Traded Fund (ETF) has revolutionised the global asset management industry since its inception three decades ago, with the result that this investment product has propelled passively managed products to the forefront of the financial market. Whilst the superficial benefits and costs to this product are often debated, the potential impact of these investment assets on the microstructure elements of the financial market, and thus its overall impact on market stability, is less well known. The necessity for a greater understanding of the potential positive or detrimental impacts of this asset class on market operation has been the driving force in recent international developments in this field. This study therefore aims to fill this gap in the literature, by evaluating the impact of ETF-related market activities, on the microstructure elements of information efficiency, and liquidity of the South African equity market. The analysis of liquidity aims to evaluate the influence of ETF introduction on the relative liquidity of its underlying assets. The sample therefore consists of 147 JSE-listed firms which are the constituents to the 23 JSE-listed, domestic equity ETFs that were listed between 2006 and 2019. In contrast, the informational efficiency analysis attempted to examine the impact of ETF ownership and trade, on the efficiency of its underlying constituents, and this analysis therefore makes use of 94 underlying JSE-listed firms, which are included in a sample of both domestic and international ETF between the periods of 2009 to 2019. The research methods made use of the event study approach, fixed effect panel data estimations, and the Generalised Method of Moments (GMM) estimation method. The results produced largely find support for Merton’s (1987) hypothesis, that the inclusion of a company into the ETF, increases investor awareness, which thus facilitates further informed trading in the underlying asset. This is evidenced by findings of improved liquidity and information efficiency in the underlying constituents to the ETFs surveyed, with the smaller, less well-known companies in the analysis enjoying the benefits of ETF membership more. The study therefore concludes that the evidence of improved market function and stability due to ETFs, is beneficial for investors who usually face adverse portfolio effects due to the high concentration of large firms on the JSE. Therefore regulators should actively encourage growth in this market by relaxing current pension fund regulations, and revising the taxation environment for ETFs to allow this asset class to become more competitive relative to the actively managed fund industry in South Africa. Keywords: Exchange Traded Funds, South Africa, liquidity, information efficiency, synchronicity, JSE.