Academic research on ETFs

1. Academic research on ETFs Susan Christoffersen University of Toronto Panel Discussion September 22, 2014

2. Why are ETFs growing? • Benefits for retail investors: • The mutual fund is not forced to trade to provide liquidity to investors entering and leaving, as experienced in an open-end fund (1) More capital gains efficient (2) Improved returns since limited transaction and trading costs • Low fees (50 bp rather than 1-2%) (1) the mutual fund is not forced to trade (2) pre-specified index investment strategy so know exactly your exposure • French (2008) estimates 67 bp improvement net returns • Benefits for institutional investors: • Only need to buy one share and not all shares in the index • Do not have to rebalance an index position • Makes it easy for institutions to hedge market risk since they can take a short position in ETFs and know exactly what they are hedging • Know exactly the market risk they are accepting and no added price risk as found with closed-end where P < NAV • Makes it easy to achieve strategic asset allocation since know the portfolio of the manager

3. Two main questions • What is critical for continued growth of ETFs? • What is the impact of this growth on capital markets?

4. Q1. What is critical to ETFs? • The role and health of the authorized participant is critical to the success of the ETF • Most ETFs have two main “market makers” or APs • Collapse of Knight Capital disrupted ETF markets with 17-20% of market trading • There are two main threats: • AP is not effective enough at keeping P close to NAV which discourages institutional investment • Outside traders start to trade against AP which reduces AP profits and may exacerbate problem #1

5. How efficient is the AP? • Many believe that the tracking error on ETFs is small because of the role of Authorized Participants • Petajisto (2013) shows that the discrepancy between ETF share prices and NAV can be substantial at different times • On average discrepancy is 14bp (not distinguishable from zero) • Standard deviation however is large: 66 bp so on average fluctuates in band 260 bp • Why? • Transactional costs and limits to arbitrage that may prevent Authorized Participants from arbitraging • Financial crisis was a time when AP had limited access to capital • AP may wait longer to intervene to earn higher profits on scarce capital

6. Pricing inefficiencies • ETF spread widens when arbitrage capital becomes scarce • Riskiness of market has large effects on the efficiency of pricing • Undermines the benefit of P~NAV, if persisted might discourage institutional investment

7. Trading against AP? • Traders know that when P > NAV for an ETF, there will be an AP who will force P to decrease • Similarly if P < NAV, the AP will buy up ETF shares • Predictability in price movements, do traders trade against this? • YES. Very popular trade for high frequency traders because it is easy to pick out • STRATEGY: Find two ETFs based on same index and buy the discounted ETFs and sell the premium ETFs

8. Trading against AP? • Profits to be made • Alphas range around10% and actually increase to 25% depending on the sample of ETFs one executes the strategy on • Market-neutral strategy with low volatility • Open question whether trading against the AP will discourage the AP from keeping P close to NAV • Could be self enforcing where the trading strategy keeps ETF prices close to NAV

9. Q2. Impact of growth in ETFs • We’ve already seen evidence of asset growth in ETFs • In 2013, 15.3 trillion in trades arose from ETF activity which is 27% of all trading on US Exchanges • 70% of cancelled trades in May 2010 flash crash resulted from ETF trades • For S&P Index, there are probably about 1.3 trillion in assets following this specific index • Total market cap of S&P is 17 trillion • Index-related trades are about 8%

10. Q2. Impact of growth in ETFs • Interferes with prices and returns of stocks • Overbuy index firms • Increased correlation between stocks in the index • Reduces diversification benefits • Feedback loops which can destabilize prices • Arising from sudden price movements on the index • Arising from demand effects • Additional volatility

11. Firms in the index From Chen, Noronha, and Singal (2004) • $915 billion S&P linked assets chasing index stocks with 10.5 trillion in market cap • About 8-10% of each stock is bought (sold) when added (deleted) • No surprise this demand has an effect on returns • Additions: price bump permanent

12. Return impact on the index • Because of the price impact on returns of the underlying stocks, there is feedback on index fund returns • Index funds are trading “against the wind” • Suppose a new firm is added to the index, all index funds have to buy the stock • BUT …. buying the stock after the price has gone up • Similar problem of selling after deletion (price has fallen) • Easy for others to trade against • Turnover drag on the index followers of around 50bp (Petajisto, 2011)

13. Comovement with index Stocks which join the S&P index tend to correlate more with the other firms in the index and less with stocks out of the index Less diversification benefits Barberis, Shleifer, and Wurgler (2005)

14. Market Instability Investors observe high market returns Invest in index funds (P > NAV) Authorized Participant needs to supply more ETF shares Low-frequency loop Bubbles Price of the index stocks increases To create ETF shares, AP will buy more index stock

15. Additional volatility From Ben-David, Frazzoni, and Moussawi (2014)

16. Conclusions Enormous benefits to ETFs and we have seen enormous growth • Threats to growth: • AP ability to keep price close to NAV • Trading against AP • Impact of growth on underlying in capital markets • Alters stock returns and creates drag on index fund returns • Changes correlations • Market instability New innovations: Active ETFs may help • Divert trades away from same group of stocks • May make it more difficult to trade against the AP with an active portfolio that is not explicit to the market