Working Paper: NBER ID: w30039
Authors: Naz Koont; Yiming Ma; Lubos Pastor; 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: Exchange-Traded Funds; Liquidity Transformation; Corporate Bond ETFs
JEL Codes: G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| active management of ETFs (G23) | facilitates liquidity transformation (G19) |
| ETF shares are more liquid than the underlying securities (G15) | due to arbitrage activities of authorized participants (APs) (G19) |
| liquidity provision by APs (E50) | mitigates price impact of investors' trades (G19) |
| inclusion of bonds in ETF baskets (G12) | improves bond liquidity during normal market conditions (G10) |
| inclusion of bonds in ETF baskets (G12) | correlates positively with their trading activity (G15) |
| inclusion of bonds in ETF baskets during significant imbalance (G15) | leads to deterioration in bond liquidity (G33) |
| APs' increased reluctance to purchase bonds (H74) | negatively impacting liquidity (F65) |
| effect of basket inclusion on bond liquidity (E43) | is state-dependent (H73) |
| positive effects of basket inclusion on bond liquidity during stable periods (G10) | negative effects during liquidity crises (F65) |