From Passive Vehicles to Active Agents

Abstract

This chapter critically examines the evolution, structure, and diverse impact of exchange-traded funds (ETFs) within contemporary financial markets. Once perceived as passive, low-cost vehicles, ETFs have transformed into dynamic agents shaping investor behaviour, price discovery, corporate governance, and financial stability. The chapter traces the developmental trajectory of ETFs, highlighting the central role of the creation and redemption mechanism in ensuring price alignment while also introducing channels for liquidity transformation and systemic risk propagation. The analysis is organized around five interconnected themes: the evolution and structure of ETFs, their influence on market liquidity, their effects on price efficiency, their effects on volatility, and governance and firm behaviour implications. Drawing from a synthesis of academic literature and policy debates, the chapter argues that ETFs are embedded in broader market microstructures, where fund sponsors, authorized participants, investors, and regulators interact in complex ways. In developing these five themes, the chapter draws on core financial economics theories, including arbitrage theory, market microstructure, information efficiency, behavioural finance, and agency-based views of corporate governance. The conclusion outlines a research agenda for addressing unresolved questions on ETFs’ role in market efficiency, corporate governance, and financial stability, particularly in the face of innovations like tokenization and cross-border ETFs. Overall, the chapter positions ETFs as pivotal actors in modern finance, necessitating nuanced regulatory and scholarly attention.