Most ETFs are designed to be passive in the sense they aim to help investors track an index rather than generating alpha. But are they really passive? Research titled Steering a Ship in Illiquid Waters: Active Management of Passive Funds, challenges this notion of passiveness by showing that ETFs are, surprisingly, much more active than we previously thought.
The study, by Naz Koont, a doctoral student at Columbia University, Columbia Business School finance professor Yiming Ma, Chicago Booth finance professor Lubos Pastor and myself, a Wharton finance professor, argues that it is important for both investors and regulators to understand this activeness, because it affects both the investment returns an investor really gets and also has important implications for financial stability.
The punchline “to be passive, an ETF has to be active” may sound paradoxical, but it reflects how the ETF machinery works in a new era of investments when the wrapper is increasingly used to capture illiquid assets such as small-cap stocks, corporate bonds, bank loans, or even bitcoin.
This evolution can also be termed “liquidity transformation”. ETFs transform liquidity in the sense that they can back up relatively liquid ETF shares by investing in relatively illiquid assets.
Liquidity transformation plus the passive nature of index-tracking allow investors to get access to otherwise hard-to-access markets. And it is indeed why more and more investors like to use these ETFs as building blocks to gain wider access to different asset classes while retaining the ability to quickly buy and sell ETF shares without worrying about price impacts.
But as with everything in finance, there is no free lunch. The gain in liquidity by investors comes with a cost. This is because ETFs have to rely on authorised participants (APs) to make ETF shares liquid. APs provide liquidity in an ETF by creating or redeeming its shares, which they do by buying or selling the underlying securities and grouping them in baskets.
They obtain newly issued ETF shares from ETF issuers in exchange for baskets of securities chosen by the issuers, then resell the new shares to investors in the secondary market. The process also works in reverse, with the APs redeeming ETF shares in exchange for a basket of securities.
What's in the basket?
These baskets are carefully designed by the ETFs in that the exact securities included in the basket differ, at times substantially, from those in the underlying index.
The study finds that a basket typically includes cash, generally five to 12% of its assets. Baskets also tend to be quite concentrated – in fixed income they include just a small subset of the bonds that appear in the underlying index. Because APs are crucial to keep ETF shares liquid, ETFs actively adjust their baskets to help APs manage the sometimes-large transaction costs they incur.
With those active adjustments in baskets, ETFs deviate substantially from their underlying index. Despite their passive image, ETFs end up being remarkably active in their portfolio management.
With those active adjustments in baskets, ETFs deviate substantially from their underlying index. Despite their passive image, ETFs end up being remarkably active in their portfolio management.
This reflects the trade-offs that an ETF investor faces. If investors get liquid ETF shares out of a less liquid index, they should know that the ETF is likely tracking the index less closely. In that sense, fixed-income ETFs are a great innovation but they are no free lunch.
The study also informs regulators about the potential financial stability risks posed by ETF becoming increasingly active in liquidity transformation. The study finds that a bond’s inclusion in an ETF basket has a significant effect on the bond’s liquidity.
Bonds included in ETF baskets benefit from improved market liquidity in normal times. But they also face larger liquidity strains during bad times, such as during the COVID-19 crisis in March 2020, when cash-strapped investors sold their ETF shares, causing concentrated, systemic, and potentially persistent selling pressures in the underlying bonds. Indeed, corporate funding costs rose sharply, and the issuance of new bonds halted.
Luckily, the Federal Reserve was smart enough to quickly step in in March 2020. They took the extraordinary move to offer to buy bonds and bond ETFs directly to help ease the credit conditions for corporations relying on bond funding.
This has prevented a major financial crisis but also led to widespread moral hazard concerns. Will ETFs be encouraged to step into even less liquid waters? If the Fed can buy bond ETFs, will they next buy stocks or equity ETFs like the Bank of Japan?
It is hard to tell. But as passive ETFs increasingly engage in liquidity transformation and become more active, these questions will only become more relevant and important. Investors and regulators need to all be more active to embrace the active evolution of ETFs.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
