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Academic research on ETFsAcademic research on ETFs
Susan ChristoffersenUniversity of TorontoPanel DiscussionSeptember 22, 2014
Susan ChristoffersenUniversity of TorontoPanel DiscussionSeptember 22, 2014
Why are ETFs growing?Why are ETFs growing? Benefits for retail investors:
The mutual fund is not forced to trade to provide liquidity to investors entering and leaving, as experienced in an open-end fund
(1) More capital gains efficient(2) Improved returns since limited transaction and trading costs
Low fees (50 bp rather than 1-2%)(1) the mutual fund is not forced to trade (2) pre-specified index investment strategy so know exactly your exposure
French (2008) estimates 67 bp improvement net returns
Benefits for institutional investors: Only need to buy one share and not all shares in the index Do not have to rebalance an index position Makes it easy for institutions to hedge market risk since they can take a short
position in ETFs and know exactly what they are hedging Know exactly the market risk they are accepting and no added price risk as found
with closed-end where P < NAV Makes it easy to achieve strategic asset allocation since know the portfolio of the
manager
Two main questionsTwo main questions
1. What is critical for continued growth of ETFs?
2. What is the impact of this growth on capital markets?
Q1. What is critical to ETFs?Q1. What is critical to ETFs?
The role and health of the authorized participant is critical to the success of the ETF
Most ETFs have two main “market makers” or APs Collapse of Knight Capital disrupted ETF markets with 17-20% of
market trading
There are two main threats:
1. AP is not effective enough at keeping P close to NAV which discourages institutional investment
2. Outside traders start to trade against AP which reduces AP profits and may exacerbate problem #1
How efficient is the AP? How efficient is the AP? Many believe that the tracking error on ETFs is small
because of the role of Authorized Participants
Petajisto (2013) shows that the discrepancy between ETF share prices and NAV can be substantial at different times
On average discrepancy is 14bp (not distinguishable from zero) Standard deviation however is large: 66 bp so on average fluctuates
in band 260 bp
Why? Transactional costs and limits to arbitrage that may prevent
Authorized Participants from arbitraging Financial crisis was a time when AP had limited access to capital AP may wait longer to intervene to earn higher profits on scarce
capital
Pricing inefficiencies Pricing inefficiencies
ETF spread widens when arbitrage capital becomes scarce Riskiness of market has large effects on the efficiency of pricing Undermines the benefit of P~NAV, if persisted might discourage
institutional investment
Trading against AP? Trading against AP? Traders know that when P > NAV for an ETF, there will
be an AP who will force P to decrease Similarly if P < NAV, the AP will buy up ETF shares
Predictability in price movements, do traders trade against this?
YES. Very popular trade for high frequency traders because it is easy to pick out
STRATEGY: Find two ETFs based on same index and buy the discounted ETFs and sell the premium ETFs
Trading against AP?Trading against AP? Profits to be made
Alphas range around10% and actually increase to 25% depending on the sample of ETFs one executes the strategy on
Market-neutral strategy with low volatility
Open question whether trading against the AP will discourage the AP from keeping P close to NAV
Could be self enforcing where the trading strategy keeps ETF prices close to NAV
Q2. Impact of growth in ETFsQ2. Impact of growth in ETFs We’ve already seen evidence of asset growth in ETFs
In 2013, 15.3 trillion in trades arose from ETF activity which is 27% of all trading on US Exchanges 70% of cancelled trades in May 2010 flash crash resulted from ETF trades
For S&P Index, there are probably about 1.3 trillion in assets following this specific index Total market cap of S&P is 17 trillion Index-related trades are about 8%
Q2. Impact of growth in ETFsQ2. Impact of growth in ETFs1. Interferes with prices and returns of stocks
Overbuy index firms
2. Increased correlation between stocks in the index Reduces diversification benefits
3. Feedback loops which can destabilize prices Arising from sudden price movements on the index Arising from demand effects
4. Additional volatility
Firms in the indexFirms in the indexEvaluation Period (1989-2000) Abnormal
ReturnsTurnover (%
increase over median trading
day)
Additions Announcement Day 5.446% 270%
Announcement to Effective Day 8.9% 1130%
Announcement +60 Days 6.189%
Deletions Announcement Day -8.46% 250%
Announcement to Effective Day -14.43% 1750%
+60 days 0.394%
From Chen, Noronha, and Singal (2004) $915 billion S&P linked assets chasing index stocks with 10.5 trillion in market cap
About 8-10% of each stock is bought (sold) when added (deleted) No surprise this demand has an effect on returns
Additions: price bump permanent
Return impact on the indexReturn impact on the index
Because of the price impact on returns of the underlying stocks, there is feedback on index fund returns
Index funds are trading “against the wind” Suppose a new firm is added to the index, all index funds
have to buy the stock BUT …. buying the stock after the price has gone up Similar problem of selling after deletion (price has fallen) Easy for others to trade against
Turnover drag on the index followers of around 50bp (Petajisto, 2011)
Comovement with indexComovement with indexStocks which join the S&P index tend to correlate more with the other firms in the index and less with stocks out of the index
Less diversification benefits
Barberis, Shleifer, and Wurgler (2005)
Market InstabilityMarket Instability
Investors observe high market returns
Invest in index funds (P > NAV)
Authorized Participant needs to supply more ETF shares
To create ETF shares, AP will buy more index stock
Price of the index stocks increases
Low-frequency loopBubbles
Additional volatilityAdditional volatility
From Ben-David, Frazzoni, and Moussawi (2014)
ConclusionsConclusionsEnormous benefits to ETFs and we have seen enormous growth
1.Threats to growth: AP ability to keep price close to NAV Trading against AP
2.Impact of growth on underlying in capital markets Alters stock returns and creates drag on index fund returns Changes correlations Market instability
New innovations: Active ETFs may help Divert trades away from same group of stocks May make it more difficult to trade against the AP with an active portfolio that is not explicit to the market