E TF R E S E AR C H AC AD EMY
OCTOBER 2015
I N D E P E N D E N T R E S E A R C H E R S ’ L AT E S T F I N D I N G S
AN EQUILIBRIUM MODEL
FOR ETF LIQUIDITY
ADDRESSING THE FEEDBACK PROBLEM IN ETF LIQUIDITY RESEARCH
Much existing research on ETF liquidity is empirical. For example, researchers
collect data on ETFs’ liquidity and the liquidity of ETFs’ underlying baskets of
securities. They then try to demonstrate a causal relationship or correlation
between one and the other.
Semyon Malamud
Professor of Finance, Ecole
Polytechnique Fédérale
de Lausanne and Swiss
Finance Institute
A problem with such approaches is that they do not address endogeneity
(feedback) effects. For example, an ETF’s liquidity is related to the liquidity
of the basket of securities in which it invests. But in turn, the liquidity of the
underlying basket is almost certainly influenced by the existence of the ETF.
What comes first—the ETF’s liquidity or the basket’s liquidity?
Separating the “chicken” from the “egg” in such empirical studies is a
challenge.
In this Expert Opinion we highlight the new research findings of Semyon
Malamud, Assistant Professor at the Swiss Finance Institute and EPFL.
Malamud takes a theoretical approach to studying ETF liquidity, which by
definition avoids the endogeneity problem.
The Endogeneity Problem: What Comes First?
ETF
Basket
Liquidity
Liquidity
[email protected]
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E TF R E S E AR C H AC AD EMY
OCTOBER 2015
I N D E P E N D E N T R E S E A R C H E R S ’ L AT E S T F I N D I N G S
WHAT’S NEW? AN EQUILIBRIUM MODEL FOR ETFs
Malamud starts from first principles, seeking to identify
and analyse the economic mechanisms involved in the
interactions between ETFs and the underlying securities
markets. The goal of the paper is to establish an ETF Capital
Asset Pricing Model (CAPM), an extension of the classical
CAPM introduced in the 1960s by Sharpe and Lintner1.
KEY RESEARCH FINDINGS
The theoretical framework set out by Malamud leads to the
following conclusions:
ETFs DON’T AUTOMATICALLY CAUSE HIGHER VOLATILITY AND
CO-MOVEMENT OF STOCKS
Many critics have argued that the existence of ETFs
increases stocks’ volatility and the tendency for stock
prices to move in sync (i.e., to higher co-movement).
Malamud’s model shows that this is not necessarily so and
that the relationship between ETFs and securities market
risk is more ambiguous. Although the existence of ETFs
does increase co-movement if levels of risk aversion are
high, particularly so for less liquid underlying assets, the
introduction of new ETFs can have the opposite effect
when risk aversion is low, reducing overall volatility and
co-movement. When risk aversion is high, the short- and
long-term impacts of the introduction of new ETFs on comovement are not significantly different. However, when
risk aversion is low, the short- and long-term impacts on
co-movement may be quite different: short-term volatility is
independent of the liquidity of the ETF’s primary market, but
long-term volatility has a non-linear (concave) relationship
with ETF’s primary market liquidity. ETFs may add to trading
volume and liquidity in the underlying securities.
Why is a new CAPM needed for a market that includes
ETFs? In the classical CAPM, risk is merely reshuffled when
the ownership of securities changes; the aggregate quantity
of risk in the market is unaltered. However, according
to Malamud, the existence of a creation/redemption
mechanism for ETFs affects the pricing and liquidity of both
the ETFs and their underlying “baskets” of securities.
In other words, ETFs should not be viewed simply as
substitutes for the securities in the fund baskets. An ETF
and its basket are exposed to different demand shocks
(surprise events that increase or decrease the demand for
securities) and there may be deviations between the value
of the ETF and the value of the basket (something traders
and investors observe empirically as a premium or discount
in the ETF’s price to its underlying net asset value).
Even if these deviations are small, the arbitrage activity
undertaken by Authorised Participants (APs) between the
ETF and the underlying basket can amplify such differences
(especially since arbitrage traders can use leverage).
According to the model, it is generally not true to argue that
ETFs detract from the trading volume and liquidity of the
underlying securities. In fact, the introduction of ETFs may
lead to an increase in liquidity in the securities markets,
even though APs require liquidity for their hedging and
arbitrage operations.
To summarise, according to Malamud, aggregate levels of
risk in the market change as a result of the existence of ETFs
and there is a “shock propagation channel” between ETFs
and the underlying securities markets.
1
S harpe, William F. (1964), “Capital asset prices: A theory of market equilibrium under conditions of risk”, Journal of Finance, 19 (3), 425–442;
Lintner, John (1965), “The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets”, Review of
Economics and Statistics, 47 (1), 13–37.
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E TF R E S E AR C H AC AD EMY
OCTOBER 2015
I N D E P E N D E N T R E S E A R C H E R S ’ L AT E S T F I N D I N G S
IMPLICATIONS FOR REGULATORS AND FOR THOSE
CONCERNED ABOUT ETFS’ IMPACT ON SYSTEMIC RISK
Under Malamud’s “CAPM for ETFs”, ETFs can transmit
demand shocks to securities markets. If regulators wish
to control the shock propagation mechanism, they may
want to control or influence primary market costs. This is
because a decrease in the costs of creation and redemption
increases the incentives of APs to create and redeem,
thereby amplifying the propagation of shocks through time.
So higher primary market costs would dampen the ability
of ETFs to transmit such demand shocks.
THE COSTS OF TRADING ETFs CAN BE LOWER THAN THE COSTS
OF TRADING THE UNDERLYING SECURITIES
The model suggests that, if the volatility of demand shocks
(is sufficiently small, ETF trading costs are always lower
than those of the underlying securities.
HIGHER PRIMARY MARKET LIQUIDITY DOESN’T ALWAYS IMPLY
HIGHER SECONDARY MARKET LIQUIDITY
Sometimes an increase in primary market liquidity can
lead to a drop in secondary market liquidity. If you create
or redeem more, tomorrow’s prices may become more
volatile (i.e., it becomes riskier for dealers to hold more
inventory). This can lead to a reduction in dealers’ appetite
for providing secondary market liquidity.
By implication, there’s also an optimal level of primary
market costs to reduce systemic risks. And ETF issuers,
via their design choices, can influence the overall riskiness
of the ETF market. In his paper, Malamud does not seek to
calibrate such an optimal level of primary market costs for
particular types of fund, but other researchers may wish to
build on Malamud’s theoretical results and seek to do so.
Malamud’s research also suggests that broad statements
such as “ETFs increase the volatility of the underlying
securities”, “ETFs increase the co-movement of securities”
and “ETFs detract from the liquidity of securities markets”
are too simplistic and, potentially, misleading. In fact, adding
new ETFs to those already in issue can lead to an overall
decrease in systemic risk. Therefore, the overall riskiness of
the ETF market does not depend on the number of ETFs in
existence or the volume of ETF assets under management.
ETF ISSUERS’ DESIGN CHOICES HAVE KNOCK-ON EFFECTS ON
THE REST OF THE ETF MARKET
According to Malamud’s model, introducing new ETFs
or increasing the primary market liquidity of one ETF
simultaneously improves the secondary market liquidity of
all other ETFs. ETF issuers’ design choices do not exist in
isolation.
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E TF R E S E AR C H AC AD EMY
OCTOBER 2015
I N D E P E N D E N T R E S E A R C H E R S ’ L AT E S T F I N D I N G S
RESEARCH PAPER - ABSTRACT
AN EQUILIBRIUM MODEL FOR ETF LIQUIDITY
Much existing research on ETF liquidity is empirical. For
example, researchers collect data on ETFs’ liquidity and
the liquidity of ETFs’ underlying baskets of securities. They
then try to demonstrate a causal relationship or correlation
between one and the other.
—— ETFs can add to trading volume and liquidity in the
underlying securities;
—— The costs of trading ETFs are usually lower than those
of trading the underlying securities;
—— Higher liquidity in the ETF primary market doesn’t
always imply higher secondary market liquidity—the
relationship is non-linear;
Such approaches, while valuable, don’t address endogeneity
(feedback) effects: it’s difficult to identify whether the ETF’s
liquidity is driving the liquidity of the basket of securities in
which it invests, or vice versa.
—— ETF issuers’ design choices (for example, the levels of
primary market costs they set) can affect the overall
riskiness of the ETF market.
Researcher Semyon Malamud gets around the endogeneity
problem by taking a theoretical, rather than empirical
approach. He aims to identify, from first principles, the
economic mechanisms involved in interactions between
ETFs and the underlying securities markets. Malamud’s
approach is a modified version of the classical Capital Asset
Pricing Model (CAPM).
According to Malamud, the risk of the ETF market does not
depend on the number of ETFs in existence or the volume
of ETF assets under management. However, since ETFs
can transmit demand shocks (unexpected changes in the
demand for securities) to the broader markets, regulators
may wish to take a deeper interest in primary market costs.
Malamud’s model suggests that there is an optimal model of
primary market costs to reduce systemic risks, although he
does not seek to calibrate this level.
The researcher’s key conclusions are:
—— ETFs don’t automatically cause higher volatility and
co-movement in stocks (Malamud shows that this
depends on the overall levels of risk aversion in the
market and on whether volatility and co-movement are
measured over the short- or long-term);
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