ETFs, Volatility, and the Weight of Uncertainty : Exploring ETFs impact on the Swedish equity market

Exchange Traded Funds (ETFs), which offer low costs to trade and high liquidity, have attracted many short-term liquidity traders. Through arbitrage channels, liquidity shocks can occur that affect the underlying securities. As a result, ETFs could increase the nonfundamental volatility of the underlying securities. Another aspect to consider is the Economic Policy Uncertainty (EPU), which has been shown in previous studies to have a strong impact on financial markets as it can lead to reduced liquidity, increased volatility and market inefficiency. This has given rise to the origin and purpose of this study which is to examine the impact of ETF ownership have on the volatility of underlying assets in the Swedish market under different levels of EPU. The dependent variable, stock volatility, and the explanatory variable, ETF ownership, was retrieved from Refinitiv Eikon’s, while EPU was retrieved its official website. To conduct the study, 291 Swedish companies listed on Nasdaq OMX Stockholm were studied over a four-and-a-half-year period between January 2020 and June 2024, resulting in 15,400 observations. The regression model was done with Ordinary Least Squares (OLS), controlling for Market capitalization, bid-ask spread, Amihud ratio, inverse share price and lagged volatility. The results showed that ETF ownership increases stock volatility, but primarily when the economy is highly and moderately uncertain. These findings support Noise Trading Theory and challenge the Efficient Market Hypothesis, indicating that the ETFs can generate non-fundamental volatility even in the Swedish market as well. The study contributes to a broader understanding of how macro factors such as EPU condition can influence the ETF ownership and volatility relationship in underlying stocks, offering practical implications for investors, and regulators.