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  5. Asset Pricing: ETFs
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Asset Pricing: ETFs

Paper Session

Friday, Jan. 5, 2024 10:15 AM - 12:15 PM (CST)

Marriott Rivercenter, Grand Ballroom Salon B
Hosted By: American Finance Association
  • Chair: Yiming Ma, Columbia University

Portfolio Trading in Corporate Bond Markets

Jeff Meli
,
Barclays
Zornitsa Todorova
,
Barclays

Abstract

Portfolio trading, a recent innovation in the corporate bond market, involves trading a basket of bonds as a single piece of risk with a single market-maker. We develop an algorithm to identify portfolio trades in TRACE, and show that portfolio trading increased from 1% of total investment grade corporate bond volumes in 2018 to 7% in 2021. The protocol reduces execution costs by over 40%, with the largest benefits accruing to the least liquid bonds. We link these gains to the ETF ecosystem; portfolios that are more easily priced and hedged using ETFs have lower transaction costs.

Limits to Diversification: Passive Investing and Market Risk

Lily Fang
,
INSEAD
Hao Jiang
,
Michigan State University
Zheng Sun
,
University of California-Irvine
Lu Zheng
,
University of California-Irvine
Ximing Yin
,
Hunan University

Abstract

Campbell et al. (2001) documents that between 1962 and 1997 correlation among stocks dropped. This pattern reversed post 1997: correlation among stocks roughly doubled in 1998-2020 from previous levels. We hypothesize and provide evidence that the rise of passive investing contributed to higher correlations among stocks and in turn higher market volatility. We find that the degree to which a stock is held by passive (index and ETF) funds strongly predicts its beta and correlation with other stocks. Difference-in-difference analyses around three market shocks – 9/11 in 2001, Lehman collapse in Sep 2008, and Covid shock in March 2020 – show that stocks with high passive holdings contributed more to market volatility. Our results are not subsumed under common holdings by institutions in general and are not explained by increases in earnings correlations. We conclude that the rise of passive investing could lead to higher correlation among stocks and higher market volatility, limiting its own benefit of diversification.

Passive Investors in Primary Bond Markets

Caitlin Dannhauser
,
Villanova University
Michele Dathan
,
Federal Reserve Board

Abstract

We provide the first evidence that passive investors participate in the primary market for corporate bonds, despite the fact that these bonds are not yet included in their benchmark index. Using two samples (daily ETF holdings of all new issuances and ETF and index mutual fund holdings of month-end issuances), we find that passive funds have higher offering day holdings in bonds with lower underpricing, especially those with negative first day performance. Offering date allocations to passive funds are negatively related to one-month and one-year bond returns and positively related to downgrades in the first year. The effect is linked to primary allocations rather than secondary market purchases or ETF creation baskets. The main findings are driven by both overallocations by underwriters to passive fund families and by fund families to their passive funds.

Passive Investing and the Rise of Mega-Firms

Hao Jiang
,
Michigan State University
Lu Zheng
,
University of California–Irvine
Dimitri Vayanos
,
London School of Economics, CEPR and NBER

Abstract

We study how passive investing affects asset prices. Flows into passive funds raise disproportionately
the stock prices of the economy’s largest firms—even when the indices tracked by the
funds include all firms. Passive flows also raise the largest firms’ return volatility the most, and
raise the aggregate stock market even when they are entirely due to investors switching from
active to passive. These effects arise because of the re-pricing of systematic and large firms’
idiosyncratic risk. We estimate that passive investing caused the 50 largest US firms to rise 30%
more than the US stock market over 1996–2020.

Discussant(s)
Ananth Madhaven
,
BlackRock
Itzhak Ben-David
,
Ohio State University
Jens Dick-Nielsen
,
Copenhagen Business School
Jian Li
,
Columbia University
JEL Classifications
  • G1 - General Financial Markets