Liquidity, style investing and excess comovement of exchange-traded fund returns

Broman, Markus S.

doi:10.1016/j.finmar.2016.05.002

Cited by 57 publications

(35 citation statements)

References 54 publications

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“…In a more recent study, Madhavan and Sobczyk (2014) adjusted for stale pricing by using a state-space model somewhat similar to that of Engle and Sarkar (2006), but they focused on quantifying the magnitude and speed of ETF price discovery across the four broad categories of domestic versus international and equity versus fixedincome funds. In addition, a few authors have analyzed other separate but related questions, such as whether style investing creates co-movement for premiums in US equity ETFs (Broman 2016) and whether premiums in equity ETFs are corrected overnight or intraday (Fulkerson and Jordan 2013).…”

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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“…This has the potential to create mispricing by exposing ETFs to correlated nonfundamental demand shocks at the investment style level. Broman () shows that the returns of ETFs comove excessively with one another: excess comovements are positive (negative) and significant across ETFs in similar (distant) investment styles. These effects are shows to be amplified in more liquid ETFs where short‐term demand is more likely to occur.…”

Section: Introductionmentioning

confidence: 99%

“…As in Broman () and Petajisto (), we discard premiums greater than 20%, which are primarily due to data errors. Premiums are also winsorized fund‐by‐fund at five standard deviations from the mean.…”

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confidence: 99%

Relative Liquidity, Fund Flows and Short‐Term Demand: Evidence from Exchange‐Traded Funds

Broman

Shum

2018

The Financial Review

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We show that highly liquid Exchange‐Traded Funds (ETFs), especially those that are more liquid than their underlying basket of securities (i.e., positive relative liquidity), are particularly attractive to investors. Using three definitions of liquidity, we find that relative liquidity predicts net fund flows, as well as inflows and outflows positively and significantly. We further document a liquidity clientele among institutional investors: (i) relative liquidity is significantly more important for short‐ than for long‐term investors; and (ii) relative liquidity is inversely related to investors’ average holding duration in the ETFs. These two findings provide evidence that relative liquidity encourages short‐term demand.

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“…Several studies have examined how ETFs affect the trading environments of their constituent securities. Staer () shows that ETF fund flows have a large impact on underlying stock returns, whereas Broman () reports that unexpected shocks to ETF trading activity or ETF price impact are correlated across funds with similar holdings. Ben‐David et al.…”

Section: Market Qualitymentioning

confidence: 99%

“…Although Broman () demonstrates that return differentials between ETFs and their net asset values comove excessively across ETFs with similar investment styles, the reported correlations in premiums and discounts are far from perfect.…”

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confidence: 99%

ETF Competition and Market Quality

Box¹,

Davis²,

Fuller

2018

Financial Management

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This paper examines competition between exchange traded funds (ETFs) that hold nearly identical portfolios of securities. We provide evidence that incumbent‐fund liquidity is negatively affected when a new ETF is added to an asset class. The degradation in liquidity is even more severe whenever both funds follow the same benchmark. We also document a decline in primary‐market activity for the incumbent ETFs after the arrival of new competitors. Furthermore, increasing the number of funds in an asset class does not put downward pressure on fund management fees. Thus, the deterioration in market quality may not be offset by decreasing costs of fund ownership.

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Liquidity, style investing and excess comovement of exchange-traded fund returns

Cited by 57 publications

References 54 publications

Inefficiencies in the Pricing of Exchange-Traded Funds

Inefficiencies in the Pricing of Exchange-Traded Funds

Relative Liquidity, Fund Flows and Short‐Term Demand: Evidence from Exchange‐Traded Funds

ETF Competition and Market Quality

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