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ETFs

Paper Session

Sunday, Jan. 8, 2023 1:00 PM - 3:00 PM (CST)

Sheraton New Orleans, Rhythms I
Hosted By: American Finance Association
  • Chair: Anna Pavlova, London Business School

Steering a Ship in Illiquid Waters: Active Management of Passive Funds

Naz Koont
,
Columbia University
Yiming Ma
,
Columbia University
Lubos Pastor
,
University of Chicago
Yao Zeng
,
University of Pennsylvania

Abstract

Exchange-traded funds (ETFs) are typically viewed as passive index trackers. In contrast, we show that corporate bond ETFs actively manage their portfolios, trading off index tracking against liquidity transformation. In our model, ETFs optimally choose creation and redemption baskets that include cash and only a subset of index assets, especially if those assets are illiquid. Our evidence supports the model's predictions. We find that ETFs dynamically adjust their baskets to correct portfolio imbalances while facilitating ETF arbitrage. Basket inclusion improves bond liquidity, except in periods of large imbalance between ETF creations and redemptions, such as the COVID-19 crisis of 2020.

The Hidden Cost of Corporate Bond ETFs

Christopher Reilly
,
University of Texas-Dallas

Abstract

I document a hidden but substantial cost associated with the liquidity transformation that corporate bond exchange-traded funds (ETFs) provide. When creating new shares, authorized participants (APs) deliver a subset of the portfolio of bonds that underlie a corporate bond ETF. This subset contains bonds that realize low future returns, reducing ETF performance by 48 basis points per annum. This loss in performance cannot be attributed to forgone compensation for risk or illiquidity, but instead results from APs utilizing information regarding future changes in net asset values to strategically deliver bonds when those bonds are expected to realize poor performance in the near future.

Index Providers: Whales Behind the Scenes of ETFs

Yu An
,
Johns Hopkins University
Matteo Benetton
,
University of California-Berkeley
Yang Song
,
University of Washington

Abstract

Most ETFs replicate indexes licensed by index providers. We show that index providers wield strong market power and charge large markups to ETFs that are passed on to investors. We document three stylized facts: (i) the index provider market is highly concentrated; (ii) investors care about the identities of index providers, although they explain little variation in ETF returns; and (iii) over one-third of ETF management fees are paid as licensing fees to index providers.
A structural decomposition attributes 60% of licensing fees to index providers' markups. Counterfactual analyses show that improving competition among index providers reduces ETF fees by up to 30%.

Discussant(s)
John Shim
,
University of Notre Dame
Yiming Ma
,
Columbia University
Yang Sun
,
Brandeis University
JEL Classifications
  • G1 - Asset Markets and Pricing