The exchange-traded fund has been hailed as one of the greatest financial innovations of the past 30 years. Unlike mutual funds, ETFs can be bought or sold at any point in the trading day in the secondary market—just like an individual company’s stock. And shares of ETFs usually trade for the same price as the net asset value of the underlying securities in their portfolios.

For investors, an ETF thus can be a relatively easy, low-cost way to passively track an index of stocks or bonds. However, the simple instrument belies a complex process that makes it work, according to research by Columbia PhD student Naz Koont, Columbia’s Yiming Ma, Chicago Booth’s Lubos Pastor, and University of Pennsylvania’s Yao Zeng. They find that passive ETFs are surprisingly active in how they operate. The researchers argue that ETFs must actively design and trade baskets of securities to facilitate “liquidity transformation,” a process that makes it possible for illiquid securities such as corporate bonds to serve as the underlying material for highly liquid shares of an index ETF.

“We argue that ETFs are active because they care not only about index tracking but also about liquidity transformation, and because only active basket management allows them to balance both objectives,” the researchers write.

Their findings shed a light on the inner workings and potential risks of the ETF market. “This may sound oxymoronic, but to be passive, index ETFs have to be active,’’ says Pastor.

To understand how ETFs are traded, the researchers studied a group of 118 ETFs from 2017 to 2020. Equity-index ETFs are more popular than their bond-index counterparts, but the researchers were interested in liquidity so they studied corporate bond ETFs. The difference between the liquidity of ETF shares and the illiquidity of the underlying securities is much greater for bonds than for stocks.

They find that ETFs create liquidity working with market makers known as authorized participants, or APs, who function as intermediaries between an ETF and investors. In the bond market, APs are typically large broker-dealers. 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.

The exact securities included in the basket differ, at times substantially, from those underlying an index. A basket typically includes cash, generally 5–12 percent of its assets. Baskets also tend to be quite concentrated, including just a “small subset of the bonds that appear in the underlying index,” write the researchers. Because this intermediary trading is crucial for the ETF market to function properly, ETFs adjust their baskets to help APs manage the sometimes-large transaction costs they incur.

Koont, Ma, Pastor, and Zeng created a model that highlights ETFs’ dual role of tracking and liquidity transformation, and it illustrates how the activities of APs absorb shocks in the market. Consider, for example, a case where 100 people want to buy 100 shares each of an ETF, but 150 people want to sell the same shares. APs can prevent the ETF shares from tanking in price, which helps liquidity and enables them to trade on short notice with investors, even impatient ones.

Granted, if the price of the shares drops, liquidity can dry up as investors think twice about buying—and APs are not obligated to step in. Their own arbitrage opportunities tend to be less attractive—and transaction costs, higher—when the underlying securities are less liquid. But when APs step back from the market, “the ETF issuer often attempts to incentivize the APs further by offering them custom baskets that APs find appealing,” Pastor explains. The model predicts, and the data confirm, that when this transformation process gets more expensive, ETFs tend to include more cash in their baskets and take a looser approach to tracking the index, which carries some cost for investors.

In March 2020, faced with massive bond redemptions during the market panic that ensued because of the coronavirus, APs didn’t step in to purchase the same bonds, thus reducing their liquidity. The imbalance, however, proved temporary. And in general, the liquidity transformation process has succeeded in keeping the market humming. “Corporate bonds are notoriously illiquid, yet corporate bond ETFs are very liquid,” says Pastor. “If you want to buy a corporate bond ETF right now and sell it 20 seconds later, you can.”

The process has also impacted the underlying bond markets. The research finds that in normal times, when a bond is included in a basket, it generally becomes more liquid—and less liquid when APs are juggling an imbalance in the market.

“Our paper offers the average investor the opportunity to look under the hood of these index ETFs,” says Pastor. “I am confident in how the machine works, but now, having written this, I also better understand its fragilities.”

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