Abstract: This paper challenges the conventional wisdom that exchange-traded funds (ETFs) are more liquid than open-end mutual funds. I build a model and establish that same-index ETFs and mutual funds provide liquidity at different horizons. Investors facing higher (lower) liquidity risk and thus shorter (longer) investment horizons prefer mutual funds (ETFs). Since they can be redeemed at NAV, mutual funds holding illiquid assets provide higher short-term liquidity, but the resulting payoff complementarities make them underperform ETFs in the long run. ETFs, however, are subject to mispricing and illiquidity in the short term due to arbitrageurs’ balance-sheet constraints. In equilibrium, both funds coexist when investors face heterogeneous liquidity needs. The model generates novel, testable predictions concerning the competition and future trajectory of index ETFs and mutual funds.
Discussant: Ruggero Jappelli, University of Warwick
Abstract: Consistent with the Efficient Markets Hypothesis, savings increasingly flow to low-cost index funds, which simply buy and hold the stocks in a major index, such as the S&P500. If this diverts capital away from moving prices towards fundamentals, increased indexing may render stock markets decreasingly efficient. We find that exogenous idiosyncratic currency shocks of similar magnitude move foreign currency-sensitive stocks significantly less when those stock are in the S&P500 index than when they are not. This effect increases in lockstep with the scale of indexing. Alternative explanations are tested and rejected. Increased indexing may thus be undermining the efficient markets hypothesis that supports its viability, and much else in the real economy.
Christian Heyerdahl-Larsen, BI Norwegian Business School
Abstract: We study how disagreement on both factor and stock-specific risk exposures across many investors and securities impacts asset prices. Our theoretical analyses predict that disagreement about factor dynamics drives larger flows into portfolios that are more exposed to the factors. These concentrated bets on the factor lead to higher volatility and reduced diversification benefits. We then test these predictions using a novel empirical setting – exchange-traded funds (ETFs). We find that when factor disagreement rises, ETFs that mimic the factor see increased flows, higher forward-looking volatility risk, and a higher forward-looking correlation among the stocks in the ETF.
