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ETFs internationalize financial risks by bringing markets closer to home.

Increased growth of ETFs and passively managed funds has recently become common. As of late, over 20% of the NYSE market capitalization comes from ETFs and their related funds. In comparison, industry-related funds have an assets total close to 30%. This is mostly due to ETFs investing in emerging markets; 84% of all ETFs invest in this area. The increase of risk exposure from investors coming from different parts of the world is also noteworthy— it rose from 15% in 2000 to 45% in 2015. A cause-and-effect relationship between these two trends seems evident. Is there any truth to this assertion?

In a recent paper, Converse et al. ( 2022 ) discovered that ETF investor flows are more strongly affected by financial risk than mutual fund flows. This was because ETFs draw investor attention more quickly to emerging global issues than traditional funds do, like economic growth and fiscal performance. Consequently, the more ETF capital a country’s market held, the more responsive its portfolio was to global financial issues.

We analyze data gathered from EPFR Global regarding fund investments to gauge the strength of both bond funds and equity funds. This data is then used to suggest a correlation between monthly investor funds and the St Louis Fed Financial Stress Index. Next, we look at growth in industrial production of each country to determine a local factor. Finally, we use these two factors to define a global factor. We then run a regression on this global factor against the other two local factors in order to prove a correlation.

In order to account for any differences in risk sensitivity, ETFs are paired with an untested dummy. We find that mutual funds investing in emerging markets have a significantly smaller negative relationship with investor flows— about 1.5 times for bonds and 1.25 times for stocks. This is due to mutual funds investing in emerging markets being more correlated to market risk than ETFs.

We find that constantly fickle investors — those with a short investment horizon — respond to spikes in volatility by purchasing ETFs with large global risks. This results in increased exposure to these funds among these investors.

Countries where the stock markets are more developed have greater international influence. This is because the effects of what’s happening at home typically pale in comparison to what’s happening across the world. The second part of our analysis pursues this idea.

Investors’ decisions impact the country in a large way.


Overall, our global risk factor determines the level of portfolio equity inflows from the balance of payments. This, in turn, drives global stock market returns. For each country, we then calculate a regression coefficient for the two variables. A larger ETF share leads to greater capital flows. The figure below shows this relationship between β and ETF shares for selected countries. This shows that portfolio and stock market returns are closely related to world events, with β being more negative when shares are higher.
Looking at this link deeper reveals that when ETFs hold a larger share of a country’s equity market, they increase portfolio inflows and stock prices by 2.5 times. This is because ETF shares impact global risk. When ETFs hold more shares, investors are more sensitive to it.

Investors’ decisions impact the country in a large way.
Overall, our global risk factor determines the level of portfolio equity inflows from the balance of payments. This, in turn, drives global stock market returns. For each country, we then calculate a regression coefficient for the two variables. A larger ETF share leads to greater capital flows. The figure below shows this relationship between β and ETF shares for selected countries. This shows that portfolio and stock market returns are closely related to world events, with β being more negative when shares are higher.
Looking at this link deeper reveals that when ETFs hold a larger share of a country’s equity market, they increase portfolio inflows and stock prices by 2.5 times. This is because ETF shares impact global risk. When ETFs hold more shares, investors are more sensitive to it.

We examine control variables related to financial integration that affect financial outcome. These include external liabilities in country-wide accounting and traditional mutual funds’ share of local equities. We find that only the use of ETFs is significant when interacting with global risk.
Due to Vanguard’s switch to the FTSE index, we are able to identify changes in ETF and mutual fund shares that aren’t related to country conditions. By tracking global financial stress indicators in the new funds, we are able to see changes in ETF and mutual fund shares related to the new event.
We find that both fund and country-level funds flow measures are closely linked to ETFs. This similarity between the two estimations shows how similar the sensitivity of ETFs to dollars is to mutual funds.

The Levy-Yeyati and Williams (2012) study found a “benchmark effect” in the capital markets that supported co-movement between similar markets through passive benchmarked instruments. These findings align with Raddatz et al. (2017) that introduced this term. This is because the study found that growth of passive benchmarked instruments contributes to an increase in synchronicity among markets and correlated global factors at the expense of local fundamentals .

The increased popularity of ETFs in open economies worldwide causes problems for emerging country leaders. This is because the global financial cycle makes it difficult to effectively implement domestic monetary policy. This leads to many leaders facing a dilemma, not a trilemma. They must decide whether to enforce capital controls or create policies that maintain financial stability.

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