ETFs, Illiquid Assets, and Fire Sales
80 Pages Posted: 16 Jul 2021 Last revised: 2 May 2023
Date Written: April 25, 2023
Abstract
Can ETFs trigger fire sales in illiquid assets? We develop and empirically examine a model where an authorized participant (AP) holds bond inventory and connects the ETF to the underlying bond market. For redemptions, the AP acts as a buffer between the two markets, holding redeemed bonds to preserve the mark-to-market value of her inventory and avoid a fire sale. For creations, the AP behaves asymmetrically, and transmits ETF purchases to the bond market to boost inventory mark-to-market values. The AP’s costs of handling creations/redemptions are paid by liquidity-demanding ETF investors via premiums/discounts. We document new empirical facts motivated by the model, and provide a novel explanation for why ETFs holding more liquid bonds traded at larger discounts than those holding illiquid bonds during the COVID-induced sell-off in March 2020. Our findings show that ETFs have advantages over mutual funds in managing illiquid assets.
Keywords: ETFs, bonds, fire sales, liquidity, COVID
JEL Classification: G01, G11, G12, G23
Suggested Citation: Suggested Citation