The effect of economic uncertainty on exchange traded fund performance and volatility in South Africa.

Abstract

Global economic uncertainty (EU) is at unprecedented levels due to technological advancements, globalization, political divisions, and growing government intervention. Economic Policy Uncertainty (EPU) exacerbates this by creating ambiguity about future outcomes, leading to cautious investment, increased volatility, and difficulties in decisionmaking. This uncertainty also weakens investor confidence and complicates risk management, with emotional factors during crises further influencing decisions and expectations, making accurate forecasting even harder for both investors and firms. Given the rapid growth in the popularity of exchange-traded funds (ETFs), this study investigates the effect of EU on ETF returns under both bullish and bearish market conditions in South Africa, while also assessing how EU influences ETF volatility. Specifically, the research examines bond and equity ETFs over the period from 2006 to 2023. The sample consists of 40 ETFs, categorized into four distinct portfolios of bond and equity ETFs tracking domestic benchmarks, and bond and equity ETFs tracking international benchmarks. EU is proxied using the Rand Merchant Bank (RMB) Bureau of Economic Research (BER) Business Confidence Index (BCI). The Markov Switching Regime (MSM) model is used to capture the effect of EU on ETF returns under varying market conditions, utilizing monthly data. In addition, Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models are used to examine the relationship between EU and ETF return volatility. The MSM results indicate that EU has a statistically significant positive effect on equity ETF returns under bullish market conditions, reflecting investor optimism in perceived recovery phases. However, this effect diminishes in bearish market conditions. The international equity ETFs portfolio did not exhibit a significant relationship with EU, reinforcing the view that global diversification helps mitigate South African-specific risks. For bond ETFs, a “flight to safety” phenomenon is observed, consistent with global patterns during periods of heightened uncertainty. The GARCH analysis reveals limited evidence that EU significantly influences ETF volatility across any of the portfolios. This research highlights the importance of behavioural finance in shaping market reactions during periods of heightened EU. The observed asymmetry in market responses to EU under different market conditions presents an opportunity for investors to exploit these differences for potential diversification benefits. The study encourages further exploration of ETF performance, particularly in emerging markets, to expand the existing body of literature on the topic. Additionally, future research should focus on addressing the current limitations and leveraging more sophisticated data and methodologies. By doing so, studies can uncover deeper insights into the behavioural and systemic drivers of ETF performance, especially in the context of EPU, helping to advance our understanding of these investment vehicles in complex financial landscapes.