An academic paper has argued that fixed income exchange traded funds (ETFs) “improve bond liquidity in general, but worsen it in periods of large imbalance between creations and redemptions, such as the COVID-19 crisis.”
Written by Naz Koont and Yiming Ma of Columbia Business School, Lubos Pastor from the University of Chicago Booth School of Business and the National Bank of Slovakia, and Yao Zeng from the Wharton School of the University of Pennsylvania, the paper, entitled ‘Steering a Ship in Illiquid Waters: Active Management of Passive Funds’, looks at the way ETFs use creation and redemption baskets to manage their portfolios. It finds that ETFs are “remarkably active” in their portfolio management, often using baskets that deviate substantially from the underlying index, and adjusting those baskets dynamically.
By analysing ETF baskets and their dynamics, the paper reports insights into the economics of ETFs and their impact on asset markets. The main insight is that ETFs are active to facilitate liquidity transformation, as ETF shares tend to be more liquid than the underlying securities, in part because authorised participants (APs) conduct arbitrage trades which tend to absorb shocks to investors’ demand for ETF shares. “When investors sell ETF shares, APs can buy and redeem them; when investors buy ETF shares, APs can create and sell them. By absorbing the trades of ETF investors, APs reduce the price impact of those trades,” it says. “APs’ arbitrage trading thus provides liquidity to investors who must trade ETFs at short notice.”
This liquidity provision requires APs to trade basket securities and thus incur transaction costs. To help reduce those costs, ETFs adjust their baskets to make them cheaper to trade. While these basket adjustments facilitate liquidity transformation, they also constrain the ETF’s index-tracking capacity.” The paper argues that ETFs are active because they care not only about index tracking but also about liquidity transformation, and because only active basket management allows them to balance both objectives. As a result of ETFs’ active basket management, there are spillover effects from basket inclusion to the liquidity of the underlying securities. Another key insight for bond ETFs is that their active basket management has significant consequences for bond market liquidity. “In normal times, a bond’s inclusion in an ETF basket makes the bond more liquid because shocks to investors’ demand for ETF shares are largely idiosyncratic,” it says. “A random mix of creations and redemptions across ETFs increases the trading activity in basket bonds, improving their liquidity.”
“That is not the case, however, in periods when investors’ liquidity shocks are systematic, resulting in imbalances between creations and redemptions,” it continues. “For example, large redemptions move many redemption basket bonds to APs’ balance sheets. The APs, who also tend to act as market makers in these bonds, may then become reluctant to purchase more of the same bonds, reducing their liquidity. The effect of basket inclusion on bond liquidity is thus state-dependent: positive in normal times but negative when there is large imbalance between creations and redemptions.”
The full paper can be found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4053844
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