Information and liquidity linkages in EFTs and underlying markets

We show that exchange-traded funds (ETFs) establish strong information links with the underlying equities but weak ones with the underlying corporate debt securities. This has several distinct effects on each asset class. First, ETFs propagate liquidity shocks to equities but not to debt securities. Second, ETF flows affect the underlying equities’ returns to a much higher degree than debt securities’ returns. Third, higher ETF ownership increases equities’ volatility but decreases debt securities’ volatility. The results are consistent with the view that the higher accessibility of equities facilitates the formation of close information links with ETFs through arbitrage, which makes equities’ prices sensitive to ETF demand shocks and creates the potential for illiquidity contagion when this link is disrupted. In contrast, the hard-to-access nature of corporate debt securities results in weak information links with ETFs which reduces commonalities between the two markets.