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

Abstract

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.

ETF Competition and Market Quality

“…() show that the value‐weighted portfolio of all equity‐based ETFs in the United States trades at a bid‐ask spread that is 20 basis points lower than the spread for the equivalent portfolio of underlying stocks. Similarly, Broman and Shum () report that between 2006 and 2012, the SPDR S&P 500 ETF traded at spreads that were roughly 18% of those for the underlying basket.…”

“…The literature also cautions that the intraday liquidity of ETFs might attract short‐term traders who introduce noise into the underlying security prices through the arbitrage of fund shares. Broman and Shum () document that there is, in fact, precisely this type of liquidity clientele among institutional investors. Malamud () introduces a theoretical model that demonstrates how the creation and redemption mechanism of ETF shares serves as a shock propagation channel that allows temporary demand shocks to leave an enduring impact on constituent security prices.…”

“…Second, Broman and Shum () argue that a more liquid underlying portfolio will facilitate the creation and redemption process of the ETF. Thus, primary‐market activity may decline because the costs of trading in the underlying securities increases after the arrival of a new fund.…”

ETF Competition and Market Quality

“…The literature also cautions that the intraday liquidity of ETFs might attract short-term traders who introduce noise into the underlying security prices through the arbitrage of fund shares. Broman and Shum (2016) document that there is, in fact, precisely this type of liquidity clientele among institutional investors. Malamud (2016) introduces a theoretical model that demonstrates how the creation and redemption mechanism of ETF shares serves as a shock propagation channel that allows temporary demand shocks to leave an enduring impact on constituent security prices.…”

“…Second, Broman and Shum (2016) argue that a more liquid underlying portfolio will facilitate the creation and redemption process of the ETF. Thus, primary-market activity may decline because the costs of trading in the underlying securities increases after the arrival of a new fund.…”