What is the role of Exchange Traded Funds in price formation mechanisms and market efficiency?

Abstract

In this paper, I examine the integral role of exchange-traded funds in modern financial markets, focusing on their impact on pricing mechanisms and market efficiency. With their unique creation and redemption processes, exchange-traded funds enhance liquidity and ensure accurate price reflection relative to their net asset values (NAVs). This ability not only stabilizes but can also amplify market volatility, especially during periods of financial turmoil. I also compare exchange-traded funds to mutual funds, highlighting their superior flexibility, lower costs, and real-time responsiveness, making them attractive to institutional and retail investors. I also examine the growing importance of thematic and environmental, social, and governance (ESG) exchange-traded funds, which align investor capital with broader social and environmental objectives and influence corporate behavior across markets. I also contrast the impact of exchange-traded funds in emerging markets with those in developed markets, finding that while exchange-traded funds in developed markets promote a stable investment environment, emerging markets offer higher growth potential but with greater risk. My thesis highlights Exchange Traded Funds' complex but crucial role in enhancing market functionality, which requires prudent regulatory oversight to balance market innovation with stability. This study contributes to a deeper understanding of Exchange Traded Funds' role and the prudent approach to managing their impact on global financial systems.