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