Do ETFs Make Markets More Fragile?

According to ETFGI (2023), global ETF assets recently topped $11.6 trillion—and by mid‑2024 had swollen to over $13 trillion. Many investors now view ETFs as efficient, low‑cost building blocks for portfolios. Many investors view ETFs as efficient, low-cost building blocks for portfolios. But as their influence grows, so do concerns: can the very tools that offer transparency and liquidity also introduce fragility when markets turn volatile?

This article challenges the assumption that ETFs are purely stabilizing forces. It explores how ETFs shape market behavior—for better and worse—and what investors should consider about their systemic effects.

Key Takeaways:

ETFs improve access and liquidity, but in times of stress may increase volatility or track errors.
Herd behavior around popular ETFs can amplify price swings across underlying assets.
Synthetic ETFs and less-liquid markets may face dislocations during selloffs.
ETF trading volume sometimes exceeds that of the underlying securities—distorting price discovery.

How ETFs Work—And Why It Matters

ETFs are baskets of securities that trade on exchanges like stocks. They offer low-cost exposure to broad or niche segments of the market. Their design relies on a mechanism called creation and redemption—in which authorized participants (APs) exchange ETF shares for the underlying securities.

In normal markets, this arbitrage helps ETF prices stay close to net asset value (NAV). But in periods of stress, this structure can fray.

During the March 2020 COVID market panic, some bond ETFs traded at steep discounts to NAV. The underlying bonds became illiquid, while ETF shares continued trading—amplifying the selloff - SEC (2020).

So what? Liquidity doesn’t always mean stability. When the ETF wrapper is more liquid than its contents, price gaps can widen quickly.

Volatility Amplifiers: The Herding Effect

ETFs are designed for passive investing—but their scale has created new feedback loops.

Many investors buy and sell entire segments of the market with one click. That efficiency can turn into momentum-driven herding. If money pours into a sector ETF, all its components may rise—even if fundamentals diverge.

Hypothetical Example: Imagine a tech ETF ballooning as retail traders pile in. Even weaker tech firms in the basket may see their stock prices rise. If sentiment shifts, outflows hit all stocks in the ETF equally—regardless of strength or weakness.

This can create a boom-bust pattern unanchored from fundamentals. And it’s particularly visible in niche or thematic ETFs, which often concentrate risk in a narrow set of companies.

Price Discovery Distortions

In theory, ETFs should mirror the behavior of their underlying assets. In practice, ETF shares often trade more than the assets themselves.

Equity ETFs often account for a large share of daily trading volume—in 2023, they represented about 20% of U.S. equity market volume, even though their component securities still traded more overall. That means ETFs can influence—not just reflect—price moves. This has implications for:

Bond markets, where underlying securities are thinly traded
Small-cap stocks, where ETF flows may overpower individual company news
Illiquid sectors, where ETF rebalancing can spike volatility

Some investors may assume ETFs simply track the market. In reality, they can shape it.

Leveraged ETFs: Built-In Feedback Loops

Leveraged ETFs aim to deliver 2x or 3x the daily return of an index—amplifying both gains and losses. But few investors realize these vehicles must rebalance daily to maintain their leverage target, regardless of market direction.

This structure introduces what’s known as volatility drag: when markets swing wildly, leveraged ETFs tend to underperform their expected return over time due to the compounding effect of daily resets.

Why this matters in market stress:

Leveraged ETFs buy into strength and sell into weakness to rebalance—potentially magnifying late-day price swings.
Their growing AUM means these flows are no longer negligible. During volatile periods, this mechanical rebalancing can become a self-reinforcing feedback loop.

So what? In times of high volatility, these vehicles can shift from passive tools to active drivers of price action—distorting markets beyond their size.

Liquidity Under Pressure

One of the main appeals of ETFs is intraday liquidity. Unlike mutual funds, they trade throughout the day. But in stressed markets, that liquidity can prove fragile.

The 2022 rate-hike cycle offers a clear example of stress in bond markets. As interest rates surged, bond ETFs—especially those tracking municipal or corporate debt—experienced sharp price declines and widening bid-ask spreads, even though their underlying bonds trade infrequently. According to the Municipal Securities Rulemaking Board (MSRB), municipal bond ETF trading volumes jumped 410% in the first half of 2022, while bid‑ask spreads on individual municipal bonds doubled to an average of 68 basis points—up 22% from Q1 and 15% year-over-year—highlighting growing frictions in price discovery during periods of volatility.

This disconnect reflects a risk: the ETF market may respond faster to headlines than the underlying assets can reprice. It creates a dynamic where the tail sometimes wags the dog.

ETFs Are Tools—Not Guarantees

Many investors benefit from ETFs’ low fees, transparency, and ease of diversification. But those same features can also mask structural weaknesses in certain scenarios.

ETFs are neither inherently stabilizing nor destabilizing. Like all financial tools, their impact depends on how they’re used—and how crowded their trades become.

ETFs & Market Structure — FAQs

Why might ETF liquidity be considered less stable in stressed markets?

ETF shares can trade more frequently than the underlying assets, which may lead to short-term price gaps when the underlying securities are slow to adjust.

What risk arises when ETFs dominate small-cap or illiquid markets?

In such markets, ETF flows may outweigh company-specific information, causing prices to move more due to fund activity than to business results.

How can leveraged ETFs affect intraday volatility?

Leveraged ETFs rebalance daily, which can result in buying during rising markets or selling during declines, sometimes amplifying end-of-day price movements.

Do ETFs always act as stabilizers during downturns?

No. While they can provide access and liquidity, in periods of stress they may widen bid-ask spreads, deviate from net asset value, or add to volatility.

Why do some investors misunderstand ETF effects on markets?

Many believe ETFs only mirror markets, but high trading volumes and rebalancing activity can influence price discovery.

How do synthetic ETFs add complexity during downturns?

Synthetic ETFs rely on derivatives instead of full ownership of securities, which can make them more vulnerable to dislocations if counterparties reduce exposure.

What structural issue was revealed during COVID-era ETF trading?

Some ETFs were more liquid than their underlying assets, leading to discounts or premiums when the underlying securities became hard to trade.

Why do investors often prefer ETFs to mutual funds?

ETFs generally offer lower fees, intraday trading, and transparency, though they also present risks such as correlation effects and possible liquidity strain.

What is volatility drag in leveraged ETFs?

Volatility drag occurs when daily resets in volatile markets reduce cumulative returns, so performance may be lower than the expected multiple over time.

What occurred with some bond ETFs during the March 2020 downturn?

Certain bond ETFs traded at discounts to their net asset value because underlying bonds were illiquid while ETF shares continued trading.