Working Paper: CEPR ID: DP17283
Authors: Naz Koont; Lubo Pstor; Yao Zeng
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. We find that ETFs dynamically adjust their baskets to correct portfolio imbalances while facilitating ETF arbitrage. Basket inclusion improves bond liquidity in general, but worsens it in periods of large imbalance between creations and redemptions, such as the COVID-19 crisis.
Keywords: ETFs; Liquidity Transformation; Market Liquidity; Active Management
JEL Codes: G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ETF basket management (F33) | liquidity transformation (E41) |
| inclusion of cash in creation and redemption baskets (G10) | liquidity management (G33) |
| active management of ETF baskets (G11) | liquidity of underlying bonds (G12) |
| bond inclusion in ETF baskets (G12) | liquidity under normal conditions (E41) |
| bond inclusion in ETF baskets (G12) | liquidity during market stress (E44) |
| adjustments to baskets (C43) | liquidity transformation (E41) |
| liquidity conditions (E41) | ETF basket adjustments (F33) |