Exchange-traded Fund Market Research Articles

ICT technologies and financial innovations: The case of exchange traded funds in Brazil, Japan, Mexico, South Korea and the United States

Exchange traded funds (ETFs), funds structured in order to mimic the performance of selected financial assets, are one of the most significant innovative financial instruments recently introduced. They have gained considerable popularity among investors due to their advantages in comparison with conventional mutual funds, investment vehicles with a significantly longer history. This paper explores empirically links between information and communications technology (ICT) penetration and the introduction of financial innovations in emerging economies. It examines the impact of increasing ICT penetration on the assets of exchange traded funds in Brazil, Mexico, Japan and South Korea and the United States over 2002–2012. The methodological framework includes descriptive statistics, logistic growth models applied to estimate ETF market development patterns, and panel data analysis used to test the hypothesized relationship between increasing ICT penetration and ETF market development. The empirical findings collectively indicate that in all countries increases in ICT penetration have been pervasive and accompanied by a rapid development of ETF markets. Furthermore, the relationship between increasing ICT penetration and ETF market development is found to be strong, positive and statistically significant in Japan, Mexico, the United States and South Korea; while in Brazil the analogous relationship is relatively weak, although still positive.

ICT Technologies and Financial Innovations: The Case of Exchange Traded Funds in Brazil, Japan, Mexico, South Korea and the United States

Exchange traded funds (ETFs), funds structured in order to mimic the performance of selected financial assets, are one of the most significant innovative financial instruments recently introduced. They have gained considerable popularity among investors due to their advantages in comparison with conventional mutual funds, investment vehicles with a significantly longer history. This paper contributes by providing extensive knowledge about the empirical links between information and communications technology (ICT) penetration and the introduction of financial innovations in emerging economies. We examine the impact of increasing ICT penetration on the assets of exchange traded funds in Brazil, Mexico, Japan and South Korea and the United States. Our methodological framework includes descriptive statistics, logistic growth models applied to estimate ETF market development patterns, and panel data analysis used to test the hypothesized relationship between increasing ICT penetration and ETF market development. Our empirical findings collectively indicate that in all countries the growth of ICT has been pervasive and accompanied by a rapid development of ETF markets. Furthermore, the relationship between increasing ICT penetration and ETF market development is found to be strong, positive and statistically significant in Japan, Mexico, the United States and South Korea; while in Brazil the analogous relationship is relatively weak, although still positive.

Exchange Traded Funds: Toward a Tailored Selection Approach

The Exchange Traded Fund market is growing, and passive investors need to have reasonable grounds for choosing this investment vehicle as well as robust selection criteria. The author motivates the assertion that a tracker performance must be assessed relative to its benchmark index and not be based on absolute returns nor fund characteristics, such as expense ratio. Furthermore, the different indicators of tracking quality used in the industry, as well as some variations, are reviewed. Using examples of three major equity indices, the author argues that Exchange Traded Fund selection cannot be based on a single performance measure assessing quality common to all investors due to their various specific investment purposes and the divergent ETFs rankings according to the different indicators. Therefore, the author highlights that Exchange Traded Fund selection should be carried in an investor-specific framework founded on statistical measurements related to tracking quality relevant for each investor.

Exchange-traded funds, liquidity and volatility

Given the exponential growth in exchange-traded fund (ETF) trading, ETFs have become a significant factor in the volatility generating process of their largest component stocks. A simple model of trading is developed for securities that are included in ETFs, and empirical support is provided for the model hypotheses. Volatility spillovers from ETFs to their largest component stocks are economically significant. These spillovers are increasing in liquidity, the proportion of each stock held by the fund, deviations from net asset value, ETF flow of funds and ETF market capitalization. The results are consistent with a positive volume–volatility relation and trading-based explanations of volatility, and are generally stronger for smaller stocks.

Seeking Optimal ETF Executionin Electronic Markets

Exchange-traded funds (ETF) have had a phenomenal run in recent years, with both their number and assets under management (AUM) growing dramatically. Despite this rapid growth, the average daily exchange-traded volume of these ETFs has stalled and now appears to be in decline. However, on-screen liquidity is not a true reflection of an ETF’s total implied liquidity, which is composed of liquidity of the underlying basket, related derivatives, correlated trading vehicles, and exchange-traded volume. Because of these properties, traders need to understand the uniqueness of ETF market microstructure and use the right trading solutions to achieve optimal execution efficiency. Using empirical statistical analysis, the authors show that for small orders on relatively liquid ETFs, institutional clients are better off using broker execution algorithms to extract liquidity without creating significant market impact. For large orders on relatively illiquid ETFs, institutional clients should leverage an electronic solution that can anonymously source block liquidity from market makers to achieve optimal execution.

An Intertemporal Study of ETF Liquidityand Underlying Factor Transition, 2009–2014

This article seeks to determine the migration of exchange-traded fund (ETF) liquidity and its factor constituents in the U.S. market over time, with the ultimate goal of making the ETF market more efficient and transparent. Using a set of factors commonly thought to impact liquidity, the authors develop a four-factor liquidity scoring algorithm (A-C liquidity score), extending the 2009 study by Agrrawal and Clark. The most liquid ETFs typically have lower bid–ask spreads, higher market capitalizations, lower expense ratios, and higher average trading volumes. The transition of ETF liquidity over the 2009–2014 period indicates that there is liquidity persistence and factor strengthening across all variables. Bid–ask spreads and expense ratios have compressed, which is a good trend for investors. Asset size and trading volume have gone up, which can be indicative of greater market participation and possibly high-frequency trading in the ETF environment. From 2009 to 2014, the ETF asset class has witnessed a phenomenal 34.9% annual growth rate, compared with a 19.8% growth rate in the Russell 3000 (the aggregate market capitalization for the ETF dataset increased from $438 billion in 2009 to $2,112 billion in 2014). The ETF ecosystem seems to be thriving as the new asset class of choice among both institutional and informed retail investors. However, there are two findings of concern. First, the overall beta of the ETFs in the study seems to have transitioned over time and moved up more than 9%. This may be due to increased cross-asset correlations, sector intertwining, global market cointegration, overlapping core constituents in ETFs, or simply a systematic upward drift in overall market risk premium; this limits portfolio diversification benefits. Second, over the five-year period, 25.7% of ETFs in the initial 622 ETF dataset (2009) were liquidated. This is an additional risk that investors and regulators have to keep in mind when evaluating ETFs. The cost of poor liquidity, overlooked by some retail investors, is often in the form of shallow market depth, high expense ratios, and a range of trade execution difficulties, besides potentially high tracking errors with the associated benchmark index. In conclusion, although ETF liquidity has grown significantly over time for most assets, there is some natural pruning, with pockets of concern. Overall, ETFs have rapidly become a viable and efficient instrument in the asset management landscape. <b>TOPICS:</b>Exchange-traded funds and applications, factor-based models, portfolio construction

Understanding the Tracking Errors of Commodity Leveraged ETFs

Commodity exchange-traded funds (ETFs) are a significant part of the rapidly growing ETF market. They have become popular in recent years as they provide investors access to a great variety of commodities, ranging from precious metals to building materials, and from oil and gas to agricultural products. In this article, we analyze the tracking performance of commodity leveraged ETFs and discuss the associated trading strategies. It is known that leveraged ETF returns typically deviate from their tracking target over longer holding horizons due to the so-called volatility decay. This motivates us to construct a benchmark process that accounts for the volatility decay, and use it to examine the tracking performance of commodity leveraged ETFs. From empirical data, we find that many commodity leveraged ETFs underperform significantly against the benchmark, and we quantify such a discrepancy via the novel idea of \emph{realized effective fee}. Finally, we consider a number of trading strategies and examine their performance by backtesting with historical price data.

Speed of Convergence to Market Efficiency in the ETFs Market

We examine the informational efficiency of prices of all exchange traded funds (ETFs) that are actively traded on the NYSE Arca, based on methodology developed by Chordia et al. (2005), and compare the resulting price formation process to that of shares traded on the NYSE and NYSE Arca. Despite the significant differences in trading costs, volatility, and informational effects between ETFs and regular stocks, we document that price adjustments to new information for ETFs occur in about thirty minutes, which is comparable to price adjustments for traditional stocks traded on Arca. In multivariate setting, we further show that the speed of convergence to market efficiency of ETFs is not only significantly driven by volume, but also by the probability of informed trading. Our analysis of the speed of convergence provides a feasible measure to assess how efficiently prices of ETFs respond to new information. We are first to utilize the short-horizon return predictability from historical order flow approach to evaluate the price formation process of ETFs and to provide evidence on the determinants of its efficiency.

Speed of convergence to market efficiency in the ETFs market

PurposeThe aim of this paper is to examine the informational efficiency of prices of all exchange traded funds (ETFs) that are actively traded on the NYSE Arca, based on methodology developed by Chordia et al.Design/methodology/approachThe authors estimate the speed of convergence to market efficiency based on short‐horizon return predictability from past order flows of 273 ETFs that were traded every day on the NYSE Arca during the first six months of 2008, and compare the resulting price formation process to that of shares traded on the NYSE and NYSE Arca.FindingsDespite the significant differences in trading costs, volatility, and informational effects between ETFs and regular stocks, the paper documents that price adjustments to new information for ETFs occur in about 30 minutes, which is comparable to price adjustments for traditional stocks traded on Arca. In multivariate setting, the paper further shows that the speed of convergence to market efficiency of ETFs is not only significantly driven by volume, but also by the probability of informed trading.Research limitations/implicationsThe findings provide direct answers and insights to questions posed in a recent SEC concept release document. The analysis of the speed of convergence provides a feasible measure to assess how efficiently prices of ETFs respond to new information.Originality/valueThe authors are first to utilize the short‐horizon return predictability from historical order flow approach to evaluate the price formation process of ETFs and to provide evidence on the determinants of its efficiency.

Funding liquidity and equity liquidity in the subprime crisis period: Evidence from the ETF market

Using index and financial exchange-traded funds (ETFs), this study explores the relation between funding liquidity and equity liquidity during the subprime crisis period. Our empirical results show that a higher degree of funding illiquidity leads to an increase in bid–ask spread and a reduction in both market depth and net buying imbalance. Such findings indicate that an increase in funding liquidity can improve equity liquidity, with a stronger effect for the financial ETFs than for the index ETFs. Our study provides a better overall understanding of the effect of the liquidity–supplier funding constraint during the subprime crisis period.

Do ETFs Increase Correlations?

Since State Street Global Advisors launched the first exchange-traded fund (ETF) in 1993, the ETF marketplace has grown considerably. In 2011, the global ETF market surpassed $1.5 trillion in assets under management with more than 4,000 funds. Although investors have come to embrace the benefits of ETFs, critics have begun to question whether these products have caused markets to function differently. More specifically, some have associated ETFs with an increase in volatility and correlations within the equity market. It is true that both volatility and correlations have risen over the past few years; however, this trend is consistent with other periods of macroeconomic uncertainty. In fact, the advantages ETFs offer investors may provide the ability to better navigate market environments that exhibit high volatility and correlations. This article explores the expansion of ETFs and shifts in the macroeconomic environment to test what impact either may have on volatility and correlations. It also studies the potential implications of these hypotheses for alpha generation. The analysis concludes that although macroeconomics has a sizable effect on correlations, the proliferation of ETFs has had only a minor impact.

Direct and Indirect Effects of Index ETFs on Spot‐Futures Pricing and Liquidity: Evidence from the CAC 40 Index

AbstractThis paper investigates how the introduction of an Exchange‐Traded Fund (ETF) directly or indirectly impacts the underlying‐index spot‐futures pricing. Using intraday data for financial instruments related to the CAC 40 index, we do not find that the spot‐futures price efficiency improvement observed after ETF introduction is explained either by the direct effect of ETF shares being used in arbitrage trades or by the indirect effect of ETF trading improving the liquidity of index stocks in the short‐run. Some of our findings suggest that the efficiency improvement could rather result from a structural change in the way index traders distribute across index markets, with the ETF market absorbing the liquidity demand from some hedgers or passive index traders.

Institutional Trading Behavior in the ETF Market

We examine the trading behavior of institutional investors in the Exchange Traded Fund (ETF) market from 1993 to 2007. We concentrate on the relation between cross-sectional institutional ETF ownership and returns, particularly on the relation between changes in ownership and future returns, between past returns and institutional ownership, and between changes in ownership across institution classes (i.e. herding). Our results do not show evidence of a significant relation between changes in institutional ownership and future ETF returns. However, consistent with the use of negative feedback investment strategies, institutional investors tend to exhibit excess demands for past losers, especially in sector and international ETFs. They also exhibit high degrees of herding behavior, with banks driving the bulk of these results. Furthermore, their herding behavior is influenced by their experience in the ETF market and by certain ETF characteristics, such as liquidity and size, suggesting an aversion for information uncertainty leads them to herd.

The influence of ETFs on the price discovery of gold, silver and oil

In this study we examine gold, silver and oil exchange traded funds (ETFs) and their relation to their respective futures instruments and underlying commodities by using intradaily data. We find that the gold, silver and oil ETFs closely track the performance of their underlying assets by using tracking error and pricing deviation metrics. It has been documented in the finance literature that price discovery occurs in the futures market. We test whether in recent times the existence of ETFs has changed the dominating role of the futures market in price discovery. We find that the availability of ETFs has shifted price discovery for gold and silver to the ETF market, while the oil market has price discovery occurring still predominantly in the futures market.

Are Trading Rules Profitable in Exchange-Traded Funds?

The Exchange-traded fund (ETF) is a burgeoning financial vehicle. Despite its growing importance, there has been a lack of empirical studies on the profitability of technical trading rules in the ETF market. This paper assesses the profitability of the On-Balance Volume indicator (OBV) on ETF trading. It is found that the trading rules associated with the OBV are able to generate handsome returns in the ETF market. This is in contrast to the conventional wisdom that funds should be bought and held.

The adverse selection component of exchange traded funds

The aim of our paper is to examine whether Exchange Traded Funds (ETFs) diversify away the private information of informed traders. We apply the spread decomposition models of Glosten and Harris (1998) and Madhavan, Richardson and Roomans (1997) to a sample of ETFs and their control securities. Our results indicate that ETFs have significantly lower adverse selection costs than their control securities. This suggests that private information is diversified away for these securities. Our results therefore offer one explanation for the rapid growth in the ETF market.

Do Institutional Investors Have Market Timing Skills? Evidence from ETFs

Using quarterly institutional holdings and a large proprietary database of institutional trades in exchange-traded funds (ETFs), we investigate whether institutional investors have market and sector timing skills. The question of whether institutional investors have superior market timing skills has been intensely debated ever since Treynor and Mazuy’s (1966) seminal study. Studies that use non-linear regressions to investigate market timing generally find little evidence of skill. Furthermore, recent literature is often critical of this regression framework. We add to this literature by using an innovative approach to directly measure the ex-post performance of institutional investors’ market timing strategies. That is, we test whether institutional investors exhibit superior market or sector timing skills based on their holdings and trades of ETFs. In contrast to the return-based measures, our ETF-based measures do not suffer from biases induced by passive timing effect or by funds following dynamic trading strategies. ETFs offer institutional investors unique opportunities to instantly establish, increase, or decrease exposure to broad or a segment of equity markets. Unlike index mutual funds, ETFs are exempt from short-sale constraints and are traded continuously during market hours. The proliferation of ETFs over the last decade has also led to excellent liquidity. According to the Investment Company Institute, the total net assets of the U.S. ETF market exceed $600 billion at the end of 2007, making it possible for institutional managers to take sizable positions. Indeed, ETFs have become a preferred investment vehicle by which portfolio managers implement directional bets on broad market movements. If institutional investors are able to time the market, we expect to observe a positive correlation between changes in institutional holdings (or trades) of ETFs and the subsequent performance of ETFs that track market indexes. We investigate this relation in both univariate and multivariate settings. We conduct statistical inferences using a bootstrap approach. In addition to market return, we also test whether changes in ETF holdings predict subsequent ETF volatility. Market volatility influences performance measures such as Sharpe ratio. Therefore, portfolio managers can improve risk-adjusted performance by timing market volatility.

Proxy Voting by Exchange-Traded Funds: An Analysis of ETF Voting Policies, Practices and Patterns

Exchange-traded funds (ETFs) are an important and growing segment of the securities markets and have amassed considerable voting power through their equity holdings. This study examined the proxy voting policies, guidelines and recent voting records of seven of the largest exchange-traded fund sponsors. We found that, among these large ETF sponsors, there is considerable variation in the voting patterns and philosophies of these funds. This variation is highlighted by how the seven funds voted during the 2008 proxy season at a sample of twenty-one specific votes on a variety of important governance and social policy issues. On one end of the spectrum, Profunds voted with management on only 5 of the 21 proposals in our sample; at the other end, Rydex voted with management on 19 of the 21 proposals, with the remaining funds falling in between.We found some evidence that the three largest ETF sponsors - Barclays Global Investors, State Street and Vanguard - who together have a dominant share of the ETF market, are somewhat less likely to vote against management on management proposals and shareholder proposals than are most of the smaller fund sponsors. On the other hand, the three largest ETFs also appear to withhold votes from incumbent directors at a greater number of companies than the smaller funds. This likely indicates the use of 'withhold' votes against directors as a substitute method for expressing dissatisfaction with certain management practices, rather than voting against management on specific proposals. Our voting review also found that funds that relied heavily or exclusively on a proxy advisory firm for their voting guidelines tended to vote against management more frequently than those that did not. The votes examined were generally consistent with the written voting policies of the funds, although we identified a few cases where votes appeared to be potentially contrary to a fund’s written voting policies. Case-by-case voting policies are utilized by many of the funds - where voting decisions are based on the specific facts and circumstances at a particular company, as well as on the issue being voted - and explain some of this consistency.There were also significant differences between the ETFs in terms of the level of detail and length of their proxy voting guidelines, with firms relying on guidelines provided by proxy advisory firms tending to have the most detailed, and also the most prescriptive, voting guidelines. Proxy voting guidelines ranged from lengthy documents describing highly detailed voting guidelines on a wide range of issues to very cursory guidelines that stipulated voting with management on virtually all issues.

Hedging index exchange traded funds

This paper presents an empirical comparison of the out of sample hedging performance from naïve and minimum variance hedge ratios for the four largest US index exchange traded funds (ETFs). Efficient hedging is important to offset long and short positions on market maker’s accounts, particularly imbalances in net creation or redemption demands around the time of dividend payments. Our evaluation of out of sample hedging performance includes aversion to negative skewness and excess kurtosis. The results should be of interest to hedge funds employing tax arbitrage or leveraged long–short equity strategies as well as to ETF market makers.

Premiums-Discounts and Exchange Traded Funds

Closed-end mutual funds present a long-standing puzzle for financial economists because they so commonly trade at substantial discounts to their net asset value (NAV) (or occasionally, premiums), thus violating the “law of one price.” Open-end funds do not have this problem because their investors are always able to sell or redeem shares at NAV. The growing population of exchange-traded funds (ETFs) fall somewhere in between: most investors acquire or liquidate ETF holdings by trading them in the market, which allows deviations between prices and NAVs. But ETFs may also be redeemed or created by deposit or withdrawal of actual shares, which tends to eliminate long-run differences between market prices and NAVs. Yet apparent differences, sometimes substantial ones, do exist. These may be partly spurious though—for example, if some of the transactions prices used in calculating NAV are stale or subject to bid-ask bounce. This article addresses the issue in the context of an errors-in-variables model, in which different potential sources of pricing errors are modeled explicitly. For some ETFs, the existence of a futures market on the same underlying index provides an additional source of information about true NAV. By contrast, NAVs for international ETFs may be based on prices for stocks in foreign markets that are closed when the ETF is trading in the U.S. Engle and Sarkar show that much of the apparent premium or discount between ETF market prices and NAVs can be explained by measurement errors, and that these are smaller and more quickly reversed for domestic ETFs—especially those with associated futures trading—than for international ETFs. <b>TOPICS:</b>Exchange-traded funds and applications, passive strategies