Steering a Ship in Illiquid Waters: Active Management of Passive Funds

102 Pages Posted: 28 Mar 2022 Last revised: 5 May 2022

See all articles by Naz Koont

Naz Koont

Columbia University - Columbia Business School

Yiming Ma

Columbia University - Columbia Business School

Lubos Pastor

University of Chicago - Booth School of Business

Yao Zeng

University of Pennsylvania - The Wharton School

Date Written: May 4, 2022

Abstract

Exchange-traded funds (ETFs) are typically viewed as passive index trackers. In contrast, we show that corporate bond ETFs actively manage their portfolios, trading off index tracking against liquidity transformation. In our model, ETFs optimally choose creation and redemption baskets that include cash and only a subset of index assets, especially if those assets are illiquid. Our evidence supports the model's predictions. We find that ETFs dynamically adjust their baskets to correct portfolio imbalances while facilitating ETF arbitrage. Basket inclusion improves bond liquidity, except in periods of large imbalance between ETF creations and redemptions, such as the COVID-19 crisis of 2020.

Keywords: Exchange-traded funds, ETFs, liquidity transformation, active management

JEL Classification: G12, G23

Suggested Citation

Koont, Naz and Ma, Yiming and Pastor, Lubos and Zeng, Yao, Steering a Ship in Illiquid Waters: Active Management of Passive Funds (May 4, 2022). Available at SSRN: https://ssrn.com/abstract=4053844 or http://dx.doi.org/10.2139/ssrn.4053844

Naz Koont

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

HOME PAGE: http://www.nazkoont.com

Yiming Ma

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Lubos Pastor (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-834-4080 (Phone)
773-702-0458 (Fax)

HOME PAGE: http://www.ChicagoGSB.edu/fac/lubos.pastor/

Yao Zeng

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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