ETFs and Liquidity Shocks

Professor Vikas Agarwal on the effects of commonality of stocks under varying market conditions

This interview was first published by the Global Association of Risk Professionals on April 13, 2018

http://www.garp.org/#!/risk-intelligence/market/liquidity/a1Z1W000003fORtUAM

Assets under management in exchange-traded funds have grown from $151 billion in 2003 to more than $3.4 trillion in 2017, according to the Investment Company Institute. 

Like stocks, ETFs trade on exchanges and, like mutual funds, represent portfolios rather than individual companies. But unlike mutual funds, they trade continuously and can track the performance of various indices.

Amid the trend toward passive investing, ETFs offer the advantages of low expense ratios and transaction costs, a high degree of diversification, simplicity and transparency, and tax efficiency.

 Due to the burgeoning size of the market, the impact of ETFs on the underlying stocks is significant. Academic research finds that ETFs increase volatility and reduce liquidity of the underlying securities. In addition, it finds that ETFs increase the co-movement in returns and liquidity of the component securities.

Vikas Agarwal, H. Talmage Dobbs Jr. Chair and Professor of Finance, J. Mack Robinson College of Business, Georgia State University, has been studying commonality in liquidity of underlying stocks owned by ETFs. 

A London Business School (University of London) PhD in finance who has served as a distinguished visiting scholar in the Securities and Exchange Commission’s Division of Economic and Risk Analysis (DERA), Agarwal has published extensively on hedge fund and mutual fund subjects. 

In this interview with Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, Agarwal discusses the workings of the ETF market and the findings of his research with Paul Hanouna and Rabih Moussawi of Villanova University and Christof Stahel of the Securities and Exchange Commission (SEC). Agarwal says that the commonality in liquidity affects investors’ ability to diversify liquidity risk, and that it comes at a price.

If ETFs are basically derivatives on underlying securities, when and why does an investor prefer to invest in ETFs rather than index futures?

ETFs provide long and short exposure to many more asset classes, styles, and segments that are not all tracked by futures. Additionally, a typical U.S. large cap long exposure through ETFs can be more efficient than the same exposure by index futures.

For example, ETFs, unlike futures, do not involve a rollover of the expiring contract, which can erode performance for investors with holding horizons spanning beyond the maturity of a futures contract.

According to BlackRock, the annualized rollover cost of a long futures position in large-cap stocks (S&P 500, Euro Stoxx 50, FTSE 100) ranges from 0.9% to 1.4%. The total expense ratio for an ETF on the same indexes can be as low as 0.05% (e.g., the Vanguard S&P 500 ETF). Hence, ETFs provide a more cost-efficient way to track an index, especially for investors with longer or uncertain trading horizons.

Additionally, ETFs provide various exposures to styles (e.g. value/growth, industries), asset classes, and geographies that are not tracked by futures or do not have existing liquid future contracts.

How are ETFs managed, and what are their structural features?

Most ETFs are structured as open-end investment companies and are governed by the same regulations as a mutual fund. Similar to index mutual funds, ETFs have fund managers. 

However, ETFs are fundamentally different from other passive or active funds registered under the Investment Company Act of 1940 since they are traded on a secondary exchange. Unlike closed-end funds, ETF shares can be created or redeemed by ETF primary market makers, called authorized participants (APs).

For U.S. equity ETFs, shares trade concurrently with the underlying basket of securities they hold, thereby providing intraday liquidity to their investors. Additionally, unlike open-end mutual funds, ETFs can be sold short.

The concurrent trading of ETFs and the securities they hold presents the challenge to uphold the law of one price. Therefore, continuously throughout the trading day, ETF prices are kept in line with the intrinsic value of the underlying securities through a process of arbitrage in which APs, market makers, as well as hedge funds and other institutional investors, participate.

How does the arbitrage mechanism work?

APs can engage in arbitrage activity by taking advantage of their ability to create and redeem ETF shares. If ETFs are trading at a premium relative to the net asset value (NAV) of their underlying securities, APs will buy the underlying securities while shorting the ETF in the secondary market until the two values equate. 

At the end of the trading day, the APs then deliver the underlying securities they accumulate during the day to the ETF sponsor in exchange for newly created ETF shares in the primary market. They then use these new shares to cover their ETF short positions.

However, ETF arbitrage is not limited to AP primary market activities, as it also takes place continuously throughout the day by hedge funds and high-frequency traders. Secondary market arbitrageurs hold long-short positions on the ETFs and the main underlying basket constituents until prices converge.

What is commonality, and why should an investor worry about commonality in liquidity?

Commonality represents the co-movement of a stock’s liquidity with the rest of the market. Higher co-movements with systematic liquidity factors imply lower ability for investors to diversify liquidity shocks, which can be crucial in market downturns.

Commonality is especially important in market downturns due to systematic liquidity dry-ups. The higher the commonality of a stock, the more likely it will exhibit liquidity withdrawals in times of market stress.

If ETFs exacerbate the commonality of stocks in their basket, then this would translate in a reduction of the possibility to diversify liquidity shocks that these stocks are exposed to, especially in stressful market conditions, which would give rise to an “ETF-specific” liquidity risk factor.

What should be the benchmark against which we measure liquidity going up or down?

We benchmark the stock to itself by including stock and date fixed effects, and thus exploiting changes in the stock commonality that are related to correlated trading by ETFs due to arbitrage. We also benchmark to other stocks with similar characteristics. In particular, we use two experiments to properly identify the causal aspect of the relation between the ETF ownership and commonality in liquidity.

How does the commonality behave during various time periods (crisis versus normal)?

Our evidence illustrates that ETF-driven commonality is not a crisis-only phenomenon but is also significant in normal times.

What are the implications of commonality in liquidity for investors and policymakers?

Our paper contributes to the policy debate of widespread implications of ETFs in security markets. Specifically, we show that as ETFs continue to grow and gain bigger ownership of stocks, it can reduce the ability of investors to diversify liquidity shocks due to an increase in the commonality in liquidity of stocks included in ETF portfolios.