ETFs, Stock Liquidity and Commonality in Liquidity, a paper co-authored by our school’s Associate Professor Wu Weili and PhD student Chang Fengyuan, was published in the 2021 1st Issue of China Economic Quarterly.
In studying the microstructure of stock markets, Chordia et al. (2000) finds that there exist visible positive correlations between the liquidity of different stocks in the market, which is called “commonality in liquidity”. This phenomenon has been constantly proved in subsequent empirical studies. Chordia et al. (2000) and Kamara et al. (2008) point out that commonality in stock liquidity indicates that stock trading costs may include a type of inseparable risk factors. Brunnermeier and Pedersen (2009) point out that liquidity depletion at the market level is the core factor that leads to financial crises, but it is precisely a manifestation of commonality in stock liquidity. This phenomenon has long existed and is very evident in China’s A-share market. Karolyi et al. (2012) finds that of the world’s 40 major stock markets, China’s A-share market ranks first by commonality in stock liquidity.
Exchange Traded Funds (ETFs), a.k.a. exchange-traded open-end index funds, refer to a type of open-end funds that adopt a passive management style, replicate or track a certain standardized index and can be listed and traded on stock exchanges. ETFs have such strengths as low trading cost, high liquidity and diversification of investment portfolios. Therefore, they have drawn the attention of more and more investors in capital markets, with their AUM rising rapidly. Different from ordinary open-end funds, ETF units exist in both the primary and secondary market. Investors can subscribe for or redeem ETF units in the primary market with physical securities, and purchase or sell ETF units in the secondary market in cash. Based on this characteristic of ETFs, investors can conduct intraday trading in the constituents of such funds, which may have two results. On the one hand, the correlation between intraday trading and day trading is relatively low, therefore intraday trading can provide liquidity to stock markets, or rather to day trading. But on the other hand, as the units of an ETF correspond to a fixed stock portfolio, intraday trading by investors in the constituents thereof may lead to common volatility in the liquidity of such constituents, namely, commonality in stock liquidity described herein.
This paper conducts an empirical study of the impact of ETFs on the liquidity of stocks in the A-share market and commonality in liquidity, comes up with and empirically examines the mechanism of how ETFs work on stock liquidity and commonality in liquidity. Through the empirical study, this paper comes to the following conclusions. Firstly, by measuring stock liquidity with the Aminvest measure, the return reversal measure proposed by Pástor and Stambaugh (2003), and turnover rate, the authors find that a higher shareholding ratio in specific constituents of an ETF results in rising stock liquidity, which indicates that the ETF provides liquidity to such stocks. Secondly, by measuring commonality in stock liquidity with the two indicators proposed by Chordia et al. (2000) and Koch et al. (2016), the authors find that a higher shareholding ratio in specific constituents of an ETF results in higher commonality in stock liquidity, which indicates that the ETF increases the liquidity risk of such stocks. Thirdly, in the A-share market, based on the exchange where an ETF is listed, and whether the constituents of an ETF are listed on a single exchange, ETFs can be divided into three categories: single-market ETFs, cross-market ETFs listed on the Shanghai Stock Exchange and cross-market ETFs listed on the Shenzhen Stock Exchange. As the settlement date for cross-market ETFs listed on the Shenzhen Stock Exchange is T+2, it is difficult for investors to complete intraday trading in the constituents thereof. However, the settlement date for the other two types of ETFs is T+0, so investors can complete intraday trading in the constituents thereof. By leveraging the exogenous difference in the settlement efficiency of various types of ETFs, this paper examines the impact of different types of ETFs on stock liquidity and commonality in liquidity. The authors find that the cross-market ETFs on the Shenzhen Stock Exchange increasing the shareholding ratio in their constituents have no impact on stock liquidity and commonality in liquidity, but the other two types of ETFs doing the same will generate a notable and positive impact on the liquidity of specific constituents and commonality in stock liquidity. The above findings show that investors’ intraday trading in the constituents of ETFs is the main means by which ETFs affect stock liquidity and commonality in liquidity.
Hence the potential contributions made by this paper are as follows. First, it finds a new driver for the phenomenon of commonality in stock liquidity in the A-share market from the perspective of demand for liquidity, further puts forward and examines the working mechanism of this driver. Second, it helps readers to understand the impact of ETFs, an important financial innovation instrument in recent years, on the quality of stock markets.
The conclusions stated herein have certain policy implications as well. Firstly, the A-share market has experienced radical ups and downs in recent years. Especially during the few stock market crashes, market liquidity was on the verge of depletion. So it was difficult for investors to sell their stocks for cash. According to the empirical findings of this paper, investors’ intraday trading in the constituents of ETFs can be deemed a source of stock liquidity, but at the same time, it boosts commonality in liquidity of such constituents, and thereby increases stock liquidity risks. Therefore, regulatory authorities of stock markets shall ensure the stability of trading and settlement rules for ETFs and prevent sudden disruptions of intraday trading from bringing liquidity risks to the constituents of ETFs. Secondly, the study shown herein provides a theoretical basis for lifting the T+1 restrictions on stock trading. There has long been a fierce debate over whether the T+1 trading restrictions should be lifted in the A-share market. But neither sides of the debate can present solid evidence to support their views. The empirical findings of this paper show that intraday trading can provide liquidity to stock markets. It follows from this that: Lifting the T+1 stock trading restrictions can boost stock market liquidity and hence the stability of share prices, which offers academic bases for policy making regarding stock markets.
