By Sam van de Schootbrugge 07-10-2020

Why ETFs Don’t Always Follow Their Underlying Market

(5 min read)
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The Study in a Nutshell

Exchange-traded funds (ETFs) are one of the most popular investment vehicles. However, there have been persistent concerns around their liquidity, especially outside of the most widely followed ETFs. A recently published Journal of Financial Economics paper sheds light on secondary market liquidity issues. Specifically, it examines how ETF prices differ to their benchmark indexes or net asset values (NAVs).
The study finds that many small ETFs do have significant deviations from their underlying asset values (tracking errors). And these tracking errors are directly linked to the ETF’s illiquidity. This impact is larger if illiquid ETFs invest in less liquid assets, even if they hold the same asset classes of the same market.

Moreover, the estimated results from the paper show that illiquid ETFs tend to reveal large absolute liquidity betas and have a positive liquidity risk premium. The annualized return due to liquidity risk is approximately 0.14%.

The results highlight that a lack of ETF liquidity is related to its expected return and variance, as well as ETF tracking errors. Also, they imply that investors investing in illiquid ETFs are more susceptible to market and liquidity risks. Instead, investors in such ETFs may want to consider investing directly in underlying portfolios or similar mutual funds.

When ETFs Lack Liquidity

In general, ETFs (for a definition, see Appendix) are traded on major stock exchanges, but their shares are created and redeemed in the primary market. This unique structure results in the existence of two prices for a single asset: (i) ETF market prices determined on stock exchanges, and (ii) net asset values (NAVs) calculated based on the value of underlying securities.

Intuitively, a no-arbitrage condition implies that the daily ETF returns and the NAV returns must be identical. Authorised participants (APs), who create or redeem ETF shares or construct the underlying ETF portfolios, are responsible for eliminating deviations. However, the arbitrage mechanism can be limited if either ETFs or the underlying assets are less liquid.

Less popular ETFs suffer from illiquidity. At the end of 2012, the top ten ETFs accounted for 61.5% of the total ETF dollar trading volume. In addition, the assets under management (AUM) of those ETFs accounted for 36% of the total AUM in the US ETF market.

For those ETFs at the other end of the distribution, a lack of liquidity means APs could find it difficult trading at desired prices at the time of setting arbitrage positions or profit realisation through unwinding. In this situation, APs in low liquidity ETFs could be reluctant to actively engage in arbitrage trading, or they could require additional returns even when available for arbitrage trading.

As a result, APs can strategically wait for a tracking error (i.e., a large arbitrage opportunity) to widen or increase the bid-ask spread to meet the additional required return on risk. This translates into higher transaction costs for investors and a delayed elimination of tracking errors. Moreover, this mispricing problem is worse if the underlying securities are also illiquid.

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