ETFs boost equity market efficiency, study finds

Exchange traded funds (ETFs) have improved the efficiency of stock markets in the developed world, new research suggests.

The study concludes that ETFs have reshaped how equity markets incorporate macro-level information to improve pricing. ETFs are investment vehicles that offer investors cost-effective exposure to market indices.

The paper was co-authored by Andrew Clare, Professor of Asset Management at Bayes Business School (City St George’s University of London), Santiago Guzman, founder and managing partner at Kendall Gateway Group, and Amir Rezaee, founder of Optimex.ai and Associate professor at ISG Business School, Paris.

Professor Clare explained: “By enabling efficient trading on macroeconomic insights, ETFs have helped align market prices with broader economic conditions – a process known as macro-efficiency."

A rock in volatile times?

The study found that the benefits are particularly strong during periods of volatility – which is when faults in the operation of markets are likely to be exposed.

In developing markets, where ETF growth has been slower, the academics found that much less macro-efficiency improvement.

Bayes Masters graduate Santiago Guzman added: “The significant improvements in macro-efficiency, especially during volatile periods, highlight the role of ETFs as vital tools for risk management in today’s financial landscape. This research underscores the pivotal role ETFs play in modern financial markets, particularly in developed economies – and the need for innovation in emerging markets to bridge the efficiency gap.”

Key findings include:

• Macro-efficiency improved in both developed and emerging markets during periods of high market volatility, with more pronounced effects in ETF-heavy markets.
• Since the 2008 Global Financial Crisis, macro-efficiency in developed markets has improved significantly - coinciding with the rapid growth of ETFs.
• Regional ETF growth often has a more significant impact on local equity market efficiency than local ETF growth, particularly in markets like Europe.

Amir Razee argued: "Because ETFs provide a useful risk management tool for investors in developed markets, our findings suggest regulators should avoid placing unnecessary restrictions on them."

The researchers also urged policymakers to encourage the development of ETF markets in emerging economies, saying this would promote market efficiency and attract institutional investors.

The study, ETF Growth and Equity Market Macro-Efficiency, will be published in The Journal of Portfolio Management.