ETF Activeness and Trade-offs
Lubos Pastor, Charles P. McQuaid Distinguished Service Professor of Finance
The past two decades have witnessed rapid growth of exchange-traded funds (ETFs): the net assets of US ETFs have increased from $66 billion in 2000 to $4.4 trillion in 2019. A widely held perception of ETFs is that they are passive in that they are designed to track the performance of a pre-defined index. However, this view overlooks a defining feature of those index-tracking ETFs (compared to open-end and closed-end mutual funds): arbitrage by authorized participants (APs) and the dynamic design of the creation/redemption baskets by ETF issuers. In tracking the underlying index, ETFs heavily rely on AP arbitrage to close any mispricing between the ETF price and the underlying net asset value. But APs, which are typically broker/dealers, are not legally bound to perform ETF arbitrage; they only perform arbitrage when they find it profitable and are subject to various market frictions. Therefore, ETF issuers optimally and dynamially design the securities that are eligible for creations/redemptions, that is, the creation/redemption baskets, which are typically a much smaller subset of the index constituents, to encourage and facilitate efficient AP arbitrage. In this sense, index-tracking ETFs are not as passive as people typically perceive; they are indeed active in the sense that they actively manage the creation/redemption baskets.
We plan to study this notion of ETF activeness to acquire a deeper understanding of the functioning and efficiency of the ETF market. We are particularly interested in exploring the characteristics of ETFs that are more active, and in analyzing how ETF issuers trade this activeness off against other ETF characteristics in various market conditions. This notion of ETF tradeoffs is linked to a previous study of fund tradeoffs in the context of actively managed open-end mutual funds (Pastor, Stambaugh, and Taylor, JFE 2020). In addition, the large and unprecendented disruptions in fixed-income ETFs in March 2020 call for a better understanding of what would have happened had the Fed not intervened and had the ETFs just relied on their own activeness.