ETF Premiums and Liquidity Segmentation

Piccotti, Louis R.

doi:10.1111/fire.12148

Cited by 26 publications

(9 citation statements)

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“…Piccotti (2015) suggested that the positive average premiums for international funds and bond funds might reflect the cost of access that investors are rationally willing to pay in partly segmented markets. In general, the premium distribution is fairly symmetrical, although it has fat tails (Petajisto 2011).…”

Section: Editor's Notementioning

confidence: 99%

Inefficiencies in the Pricing of Exchange-Traded Funds

Petäjistö¹

2017

Financial Analysts Journal

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In late 2008, some investors spotted an attractive opportunity to buy municipal (muni) bonds or junk bonds, because both types of bonds had declined dramatically in value in the immediate aftermath of the Lehman Brothers collapse, arguably more than could be justified by realistic expectations of future defaults. Exchangetraded funds (ETFs) provided a convenient new vehicle for investors to take advantage of this opportunity: Any investor, including a retail investor, could easily buy a diversified portfolio of muni bonds or junk bonds, pay a low expense ratio, trade positions intraday, and use leverage to capitalize more aggressively on the opportunity. Efficiently executing such trades with ETFs, however, turned out to be more complicated.Two muni bond funds (tickers: PZA and MLN) both offered exposures to very similar portfolios of long-term muni bonds diversified across the entire United States. But with respect to their pricing, one was sometimes trading at a premium relative to its net asset value (NAV) whereas the other was trading at a discount at exactly the same time. The difference in the end-of-day premiums between the two funds varied from about +7% to -3% of NAV (Figure 1). Junk bond ETFs exhibited similar behavior, with the difference in premiums between the two largest funds (tickers: JNK and HYG) varying from +7% to -11% of NAV. The differences in premiums were driven by mean-reverting shocks to prices; that is, it was enormously important for an investor to correctly pick which fund to trade each day. Such pricing behavior was particularly surprising in the junk bond ETFs, given that each fund had several billion dollars Inefficiencies in the Pricing of Exchange-Traded FundsVolume 73 Number 1 cfapubs.org 25 in assets and traded large volumes every day with tight bid-ask spreads.Although the magnitudes in these examples are unusually large, 1 this article provides empirical evidence that smaller inefficiencies in the pricing of ETFs are not limited to a few funds or a particular period. In fact, the cross section of ETFs routinely exhibits some economically significant differences between the ETF share price and the value of the underlying portfolio, especially in some asset classes, indicating that the unsophisticated investor may face an unexpected additional cost when trading ETFs.Given the lack of attention that ETF premiums have received from investors, many of them appear implicitly to assume that ETF prices stay extremely close to NAVs. This assumption may be understandable because of the arbitrage mechanism that exists for ETFs: If the price is below the NAV, an arbitrageur can purchase ETF shares, redeem them for the underlying assets held in the ETF portfolio, and then sell the underlying assets at their prevailing market prices, which add up to the fund's NAV. 2 If the ETF price is higher than the NAV, an arbitrageur can do the reverse and create new ETF shares from the underlying assets. This action generates a pure arbitrage profit, minus the transaction costs of buying or sellin...

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Section: Editor's Notementioning

confidence: 99%

Inefficiencies in the Pricing of Exchange-Traded Funds

Petäjistö¹

2017

Financial Analysts Journal

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“…Several researchers pursued to identify possible explanations for the exhibited tracking errors by index funds, and Piccotti (2018) showed that ETFs with larger net asset value (NAV) tracking error standard deviations (TESDs) tended to trade at higher premiums, and claimed that TESD had the desirable properties as a liquidity segmentation measure. Saunders (2018), for his turn, analysed 93 country-specific ETFs from 47 different countries and found evidence that the ETF expense ratio was a significant explanatory variable for tracking error, while Akhigbe et al (2020) suggested that tracking error is a determinant for ETFs' likelihood of closure.…”

Section: Review Of Literaturementioning

confidence: 99%

Do Market Conditions Affect the Tracking Efficiency of Exchange-traded Funds? Evidence from Developed and Emerging Markets

Neto

Klötzle

Pinto

2021

Global Business Review

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This study examines the tracking efficiency of a sample of exchange-traded funds (ETFs) from seven different emerging and developed markets, in bullish and bearish market conditions, using the data from daily closing prices. It seeks to address two major questions. First, do ETFs from both developed and emerging markets have the same behaviour regarding tracking their underlying indexes? Second, is ETFs tracking ability affected by events that could change market conditions from a bullish to a bearish pattern, and vice-versa? Our findings suggest that tracking error appears to be higher in emerging markets when compared to developed markets. Furthermore, tracking error was found to be relatively higher in bearish conditions for developed markets, while this was quite the opposite in emerging markets.

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“…Positive effects of the ETFs diffusion have attracted much less attention of researchers and are rarely discussed; they include: extension of the group of investors accessing financial markets, attracted by the features of ETFs such as their diversity or other benefits in relation to the conventional funds (see details in Table 1 ); increased liquidity of the securities whose prices are tracked by passive ETFs due to, above all, improved price discovery mechanism [ 13 , 27 , 28 , 29 , 30 ] or relaxation of the short-sale constraints [ 31 ]. However, there are also studies that provide evidence for the opposite effect, i.e., decreased liquidity (e.g., [ 23 , 32 , 33 ]); potential positive effects of the greater financial openness stemming from the development of cross-listed ETFs or funds offering exposure to foreign assets [ 34 ]. …”

Section: Etfs In the Financial System: Selected Theoretical Issuesmentioning

confidence: 99%

“…increased liquidity of the securities whose prices are tracked by passive ETFs due to, above all, improved price discovery mechanism [ 13 , 27 , 28 , 29 , 30 ] or relaxation of the short-sale constraints [ 31 ]. However, there are also studies that provide evidence for the opposite effect, i.e., decreased liquidity (e.g., [ 23 , 32 , 33 ]);…”

Section: Etfs In the Financial System: Selected Theoretical Issuesmentioning

confidence: 99%

Exchange-Traded Funds on European Markets: Has Critical Mass been Reached? Implications for Financial Systems

Marszk

Lechman

2020

Entropy

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Exchange-traded funds (ETFs) are one of the most rapidly expanding categories of financial products in Europe. One of the key yet still unanswered questions is whether European ETF markets have reached the size at which they could affect the financial systems. In our study, we examine 13 European countries during the period 2004–2017 in order to trace whether the share of ETFs in the total assets of investment funds has reached the ‘critical’ level that makes possible their further growth and can be associated with an influence on the financial system. We use a novel methodological approach that identifies the ‘critical mass’ along diffusion trajectories. Our results show that, in 10 countries, the share of ETFs in assets of investment funds increased. Still, in most countries, the share of ETFs did not exceed 1%. Estimates of the diffusion models indicate that the process of growing shares of ETFs was most dynamic and relatively most stable in Switzerland and United Kingdom. Results of the critical mass analysis imply that its achievement may be forecasted exclusively in these two cases. However, even in such cases there is no substantial evidence for a possible significant influence of ETFs on the local financial systems.

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ETF Premiums and Liquidity Segmentation

Cited by 26 publications

References 61 publications

Inefficiencies in the Pricing of Exchange-Traded Funds

Inefficiencies in the Pricing of Exchange-Traded Funds

Do Market Conditions Affect the Tracking Efficiency of Exchange-traded Funds? Evidence from Developed and Emerging Markets

Exchange-Traded Funds on European Markets: Has Critical Mass been Reached? Implications for Financial Systems

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