ETFs, Illiquid Assets, and Fire Sales

58 Pages Posted: 16 Jul 2021 Last revised: 10 May 2022

See all articles by John J. Shim

John J. Shim

University of Notre Dame - Mendoza College of Business

Karamfil Todorov

London School of Economics & Political Science, Department of Finance; Bank for International Settlements

Date Written: May 9, 2022

Abstract

We develop a novel explanation for bond exchange-traded funds’ (ETFs) premiums and discounts based on two main variables: baskets (the portfolio of bonds that are exchanged for ETF shares), and authorized participants’ (APs) inventories. We introduce a novel methodology to infer baskets and show that they often represent a small fraction of ETF holdings – a fact that we call “fractional baskets.” We show that ETFs with more pronounced fractional baskets exhibit more persistent premiums and discounts. To study the role of inventory, we develop a simple model with the possibility of a fire sale in bonds. The model illustrates that when APs hold inventory in the underlying bonds, they act as a buffer between the ETF and the bond market and help mitigate fire sales. We find empirical support for the model’s predictions, and show that it can help explain why ETFs holding more liquid bonds traded at larger discounts during the COVID-induced market stress. Our findings also suggest that ETFs may be more effective in managing illiquid assets than mutual funds.

Keywords: Bonds, ETFs, Fire Sales, Liquidity, COVID

JEL Classification: G01, G11, G12, G23

Suggested Citation

Shim, John J. and Todorov, Karamfil, ETFs, Illiquid Assets, and Fire Sales (May 9, 2022). Available at SSRN: https://ssrn.com/abstract=3886881 or http://dx.doi.org/10.2139/ssrn.3886881

John J. Shim (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States

Karamfil Todorov

London School of Economics & Political Science, Department of Finance ( email )

London
Great Britain

HOME PAGE: http://ktodorov.com

Bank for International Settlements ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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