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.
