Our paper, however, is significantly different from theirs in several aspects. First, our paper focuses on liquidity spillover while focusing on volatility spillover. Second, Krause et al. (2014) study only the volatility spillover from an ETF to its largest component stocks. By contrast, we provide an entire perspective of the liquidity spillover as we consider the spillover effect of all underlying stocks. This approach allows us to simultaneously account for the spillover effect between liquidity, volatility, and return.
An ETF or an Exchange Traded Fund, is a type of security that tracks an index, sector, commodity, or other asset, which can be sold on the stock exchange. It can track either the price of a commodity or bonds or track specific strategic investments. By daily trading volume, the S&P 500 SPDR (SPY), Invesco QQQ (QQQ), and Financial Select SPDR (XLF) tend to be among the most active ETFs. The profiles of these two similar ETFs can lead to different relative levels of liquidity. Investors might find it easier and more cost-effective to trade shares of Alpha ETF than Beta ETF, despite both ETFs tracking the same index. NAV provides a gauge of what an ETF or mutual fund’s share is worth intrinsically, making it a fundamental metric for fund investors.
Stock liquidity and default risk
This evaporation of liquidity across markets can be caused by the co-movement of liquidity (e.g., liquidity commonality) or the propagation of liquidity shocks (e.g., liquidity spillover) (Cespa & Foucault, 2014). They are among the first who directly study the liquidity spillover in financial markets. We expand the empirical analysis of liquidity spillover into ETF and underlying markets https://www.xcritical.in/ and contribute to the literature by providing a direct measure of liquidity spillover and a comprehensive analysis of its determinants. We also examine the effect of ETF illiquidity on ETF tracking errors depending on how ETFs are structured. Our empirical analysis shows that tracking errors of the in-kind type of ETFs are less sensitive to ETF illiquidity than other types of ETFs are.
Passive management and the creation/redemption process can help minimize capital gains distributions. Each of these capital markets players contributes to ETFs trading more efficiently throughout the day, which benefits both buyers and sellers. There are also economic benefits for the capital markets participants.
An increase in the short-term rate reduces the liquidity spillover, whereas a rise in the default spread increases the liquidity spillover. Specifically, we find that the liquidity spillover between the ETF and its component stocks is higher when short-sale restrictions lessen. Our paper investigates market-level determinants of the liquidity spillover between the ETF and its underlying portfolio. Liquidity spillover shares similar market-level determinants to liquidity commonality. These findings are consistent with the “wealth effect” theory of financial contagion of Kyle and Xiong (2002), which argues that increased risk aversion in the marketplace intensifies liquidity spillover among asset classes.
ETFs actually operate in a fundamentally different ecosystem to other instruments that trade on stock exchanges, such as individual stocks or closed-end funds. Whereas these securities have a fixed supply of shares in circulation, %KEYWORD_VAR% ETFs are open-ended investment vehicles with the ability to issue or withdraw shares on the secondary market according to investor supply and demand. Second, ETFs have distinct characteristics that stocks do not possess.
- The real-time trading feature of ETFs provides intraday liquidity, allowing investors to execute trades throughout the trading day.
- ETFs are open-ended, meaning units can be created or redeemed based on investor demand.
- The “secondary market” liquidity seen on exchanges is important for ETF investors and traders.
- It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purposes.
- Liquidity spillover shares similar market-level determinants to liquidity commonality.
- He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
In addition, ETFs are similar to closed-end funds (CEFs) in that they are traded on exchanges.4 Unlike CEFs, the total number of shares can be increased or decreased depending on market demand and supply. In other words, ETFs are designed to combine the creation and redemption process of open-end funds with the continuous trading of the CEFs. These characteristics form the crucial mechanism that enables the facilitation of arbitrage between the ETF and its underlying assets.
Illiquidity and stock returns: cross-section and time-series effects
We also investigate factors that may affect the gap between ETF and underlying liquidity. First, when an ETF is traded on the market, it has its own trading volume, return volatility, market capitalization, and market price. These trading characteristics reflect both inventory costs and the information asymmetry of the traded security (Stoll, 2000; Van Ness et al., 2001). In particular, we look at discrepancies in market capitalization and trading volume between an ETF and its underlying stocks.
The information provided on the Site is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. There can be no assurance that a liquid market will be maintained for ETF shares. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions. Important Risk Information
There can be no assurance that a liquid market will be maintained for ETF shares.
Additionally, we provide a broader analysis of factors affecting liquidity spillover, including macroeconomic variables and ETF arbitrage activities. First, our research sheds more light on the liquidity spillover topic, which is still under-researched despite its significance. Liquidity plays a crucial role in the financial market, affecting asset pricing and market stability (e.g., Pástor & Stambaugh, 2003). As a result, the simultaneous dry-up of liquidity between different asset classes or geographic markets is of great interest to market regulators, practitioners, and researchers.
Find the right ETF for you
Fidelity’s factor ETFs aim to provide exposure to the desired factor while minimizing risk. The latest Fidelity U.S. Multifactor ETF (FLRG) targets U.S companies with strong exposure to value, quality, low volatility, and momentum factors with constrained exposure to the size factor. Liquidity
The ability to quickly buy or sell an investment in the market without impacting its price. An ETF has two main components – liquidity of the ETFs traded on the exchange and the liquidity of the individual assets in an ETF.
The first U.S. active ETF, the Bear Stearns Current Yield Fund, was launched in 2008, fifteen years later than the birth of the first passive U.S. ETF.1 Although passive ETFs still dominate the ETF industry, accounting for 98% of industry assets under management (AUM), active ETFs have experienced impressive growth. Compared to mutual funds, active ETFs provide investors with a relatively liquid and convenient way to employ alpha-generating strategies, as they offer intraday liquidity, tax efficiency, and lower fees.
Suppose a firm named GreenTech ETF tracks the clean technology sector. One day, a breakthrough invention in solar energy creates waves of excitement in the market. Investors move to buy shares of GreenTech ETF to capitalize on this trend.
In summary, our overall empirical results confirm that ETF illiquidity is a very important factor affecting ETF tracking errors. In summary, the results of this research reveal that lack of ETF liquidity is related to its expected return and variance, as well as ETF tracking errors. To the best of our knowledge, ours is the first comprehensive empirical study to examine the liquidity effects in the ETF market in relation to returns, risks, and tracking errors by using the entire US ETF market data. Extending the literature of liquidity effects on asset returns, this study shows that the liquidity of ETFs affects their returns or volatility. As a result, trading illiquid ETFs can increase the cost of market making and raise the transaction costs of ETF investors. Active exchange traded funds (ETFs) are less liquid than their underlying portfolios.
These results imply that ETF companies could choose the in-kind method strategically instead of the cash method when they are able to easily construct the assets of the index at the time of the fund inception. We employ ETF portfolio holding data to examine the extent to which ETF illiquidity affects ETF tracking errors owing to liquidity differences in underlying assets. We select only non-leveraged US stocks-based ETFs to investigate the effects of underlying asset illiquidity and ETF illiquidity on the tracking errors. We find that both underlying asset illiquidity and ETF illiquidity affect ETF tracking errors. More important, the analysis confirms that illiquidity of ETFs investing in less liquid assets can have a greater impact on their tracking errors even if they hold the same asset classes of the same market.
Investors with large ETF trades can also tap into primary market liquidity by working with an authorized participant to create or redeem ETF shares directly with the fund company. ETF liquidity is based on the dynamics in the dealer and secondary markets. Dealers acting as APs can create and redeem ETF shares to meet supply and demand changes in the ETF and keep its market price in line with its NAV. On the secondary market, ETF shares with higher trading volume and tighter spreads are usually more liquid. As with any financial security, not all ETFs have the same level of liquidity. An ETF’s liquidity is affected by the securities that it holds, the trading volume of the securities held, the trading volume of the ETF itself, and the investment environment.
