Do exchange-traded fund flows increase the volatility of the underlying index? Evidence from the emerging market in China

Studying 70 Chinese equity exchange-traded funds (ETFs), we show that daily ETF flows significantly increase both the total volatility and the fundamental volatility of the underlying index on the next trading day. More specifically, it is the forward-looking flow component which captures APs' share creation/redemption activities beyond their role of market makers that can significantly predict the two types of volatility. Moreover, ETF arbitrage (ETF's information share) enhances the effect of forward-looking flows on the total volatility (fundamental volatility) of the index. Furthermore, the relationships between forward-looking flows and the two types of index volatility show a two-way contagion.