A Three-Trillion-Dollar Question: Why Trade ETFs Instead of Their Underlying Assets?

Abstract

One potential answer is that, according to information-based theories, ETFs should be more liquid than their underlying assets. However, this prediction does not hold for over 90% of US-equity ETFs. We propose a “convenience” hypothesis: investors trade ETFs partly for convenience, for which, we estimate, they pay an annual intermediation cost of over 2% of market capitalization. Consistent with our hypothesis, the measured intermediation cost is indeed larger when there are a priori reasons to expect larger convenience; that is, when the underlying index is more volatile, an index reconstitution is approaching, or the ETF provides embedded leverage.

Keywords: Financial Innovation, ETF, Information Sensitivity, Convenience, Speculation, Leverage.

JEL Classification: G11, G23