ETF Trading and the Bifurcation of Liquidity
57 Pages Posted: 14 Jan 2020 Last revised: 15 Jan 2020
Date Written: November 14, 2019
Passively managed exchange traded funds (ETFs) are a financial technology that has risen dramatically in the last two decades. Over the same period liquid stocks have become more liquid while illiquid stocks have not experienced a similar improvement. We model investors shifting from trading individual stocks to trading ETFs and generate predictions consistent with the documented bifurcation in liquidity. Using daily ETF creation and redemption activity, we provide empirical evidence that closely matches the model's predictions. The results show that the effects of ETFs on underlying asset markets are driven by their index replication strategy.
Keywords: exchange-traded funds, passive investment, index, replication strategy, liquidity
JEL Classification: G11, G12, G20
Suggested Citation: Suggested Citation