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E-MailItzhak Ben-David is the Neil Klatskin Chair in Finance and Real-Estate at The Ohio State University’s Fisher College of Business. This post is based on a forthcoming article, submitted to the Annual Review of Financial Economics, by Professor Ben-David; Francesco Franzoni, Professor of Finance, University of Lugano (USI) and Senior Chair at the Swiss Finance Institute; and Rabih Moussawi, Assistant Professor of Finance at the Villanova School of Business.
Since the mid-1990s, exchange traded funds (ETFs) have become a popular investment vehicle due to their low transaction costs and intraday liquidity. ETFs issue securities that are traded on the major stock exchanges, and, for the most part, these instruments aim to replicate the performance of an index. ETFs have shown spectacular growth. By mid-2016, they represented about 10% of the market capitalization of securities traded on US stock exchanges. [1]
ETFs have similarities and differences relative to other pooled investment vehicles. ETFs either hold a basket of securities passively (physical replication) or enter into derivative contracts delivering the performance of an index (synthetic replication). They issue securities (mostly shares) that are claims on the underlying pool of securities. ETF shares are traded on stock exchanges, and investors can take either long or short positions. Two mechanisms keep ETF prices in line with those of the basket that they aim to track: primary and secondary market arbitrage. The first mechanism involves the creation and redemption of ETF shares by authorized participants (APs), which are the official market makers for a given ETF. When ETF prices and the prices of the underlying securities diverge, APs typically buy the less expensive asset (ETF shares or a basket of the underlying securities) and exchange it for the more expensive asset, leading to the creation or redemption of ETF shares. The second type of trade, consisting of long and short positions in the secondary market, retains some uncertainty with respect to the horizon over which price convergence will occur; thus, it is an arbitrage only in a loose sense.
ETFs have received much attention from the retail and asset management industry following a secular rise of passive investment. Passive asset management has expanded in recent decades, raising questions about what is driving this phenomenon and its implications for financial markets. While some researchers view this trend as evidence that financial markets are becoming more efficient, others warn that passive investments may have adverse effects on price efficiency. Several studies document that ETFs capture market share that was previously taken by traditional passive investment vehicles like index mutual funds, closed-end funds, and index futures.
The academic literature debates the effect of ETFs on information efficiency in financial markets. A distinct feature of ETFs is that they require active arbitrage activity so that ETF prices indeed track the prices of the underlying index. Some researchers have raised the concern that this mechanical basket arbitrage trading can serve as a channel for the propagation of liquidity shocks across markets and deteriorate the quality of prices. This concern is especially acute given that ETFs are traded by high-turnover investors, who potentially impound liquidity shocks into prices at higher frequencies. The empirical evidence shows a causal relation between ETF ownership and return volatility, justifying these concerns. Similarly, ETF ownership appears to induce excessive correlation of the securities in their baskets. Finally, recent episodes of extreme market turbulence (e.g., the Flash Crash on May 6, 2010, and the events of August 24, 2015) have revealed that the liquidity provision in ETFs can display sudden dry-ups.
Overall, ETFs have transformed the asset management world by introducing low-cost investment vehicles that are traded continuously. The academic literature acknowledges this financial innovation but also points to some potential weaknesses that appear to be sufficiently important to draw regulatory scrutiny.
The complete article is available for download here.
Endnotes:
1Exchange traded pooled investment vehicles are collectively designated as exchange traded products (ETPs). These include ETFs; exchange traded notes (ETNs), which are senior debt notes and do not invest in a portfolio of securities or a portfolio of derivatives on those securities; and exchange traded commodities (ETCs), which provide investors exposure to individual commodities or baskets and can be structured as funds or notes. In this survey, we restrict our attention to ETFs, which have been the main focus of the literature, given that they hold 95% of the assets in the sector in the United States.(go back)
