ETF Design and Asset Markets
61 Pages Posted: 14 Jan 2020 Last revised: 29 Jan 2021
Date Written: January 20, 2020
This paper theoretically and empirically shows that passive investing has heterogeneous effects on asset markets. We develop a model which predicts that funds optimally underweight illiquid index assets. Instrumenting for trading activity from exchange traded funds (ETFs), we show that ETF trading reduces the market quality of liquid assets but does not impact the market quality of illiquid assets. The effects are stronger for funds that explicitly sample their underlying index, compared to funds that are fully replicating. Thus, the effects of passive investing on asset markets depend on how intermediaries replicate their target index.
Keywords: exchange-traded funds, passive investment, index, replication strategy, market quality
JEL Classification: G11, G12, G20
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