Arbitrage and the Trading Costs of ETFs

By |June 16th, 2022|Transaction Costs, Research Insights, Larry Swedroe, Academic Research Insight, ETF Investing|

This article examines ETF creations and redemptions around price deviations and finds that the expected arbitrage trades are relatively rare in a broad sample of equity index ETFs. In the absence of these trades, price deviations persist much longer. Creation and redemption activity appears to be constrained when exchange conditions would lead to a costlier arbitrage trade, and the size of the price deviations mainly impact the likelihood rather than the amount of trading. The authors also find some evidence that creations and redemptions are less likely to trade on price deviations when they would be required to trade the underlying stocks against broad market movements. Their results suggest that several factors may discourage the built-in ETF arbitrage mechanism and that investors may receive poorer trade execution in these conditions as a result.

Options Hedging & Leveraged ETFs in Market Swings

By |June 1st, 2022|Options, Research Insights, Guest Posts, Academic Research Insight, ETF Investing|

Earlier this year, GameStop stock rose like crazy in only a few hours with the effects of broker-dealer options hedging spurred by retail investor buying pressure. And from February to March 2020, options trading activity was also pointed to as a contributor to stock swings in the Covid-19 selloff. The market dropped 30% and then recovered quickly over the following weeks. It has been documented that the need for market makers to hedge their positions with options (given rapid changes in stock prices) can contribute to market and stock price swings. However, might there be other factors also at play in these types of stock and market fluctuations? 

Can Market Maker Capital Constraints Result in Mispricing of ETFs?

By |April 18th, 2022|Research Insights, Basilico and Johnsen, Academic Research Insight, ETF Investing|

Capital constraints of financial intermediaries can affect liquidity provision. We investigate whether these constraints spillover and consequently cause contagion in the degree of market efficiency across assets managed by a common intermediary. Specifically, we provide evidence of strong comovement in pricing gaps between ETFs and their constituents for ETFs served by the same lead market maker (LMM). The effects are stronger for ETFs that are more illiquid and volatile, when the underlying constituents of the ETFs are more costly to arbitrage, and for LMMs with more constrained capital. Using extreme disruptions in debt markets during COVID-19 as an experiment, we show that non-fixed income ETFs serviced by LMMs managing a larger fraction of fixed income ETFs experience greater pricing gaps. Overall, our results indicate that intermediaries’ constraints indeed influence comovements in pricing efficiencies.

Shorting ETFs: A look into the ETF Loan Market

By |April 11th, 2022|Transaction Costs, Research Insights, Basilico and Johnsen, Academic Research Insight, ETF Investing|

We find that exchange-traded fund (ETF) lending fees are significantly higher than stock lending fees. Two institutional features unique to ETFs play significant roles in explaining the high fees. First, regulations restrict investment companies, such as mutual funds and ETFs, from owning ETFs. As these institutions are key lenders, their absence reduces the lendable supply in the ETF loan market. Second, while the create-to-lend (CTL) mechanism alleviates supply constraints when borrowing demand increases, its efficacy is limited by the associated costs and frictions. Our results speak to the limits to arbitrage in the ETF markets.

ETF Tax Efficiency isn’t Always Efficient

By |February 25th, 2022|Research Insights, Guest Posts, Tax Efficient Investing, ETF Investing|

Compared to mutual funds or separately managed accounts, ANY benefit from redeeming in-kind is a bonus. That being said, not all ETFs and situations are created equal when it comes to tax efficiency, and the "golden rule" always applies - when given the option, the IRS wants to create scenarios where they receive tax dollars now instead of later. Here are some big-ticket items that cause inefficiencies (read as taxes…), many related to the “golden rule” above.

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