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

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. We find that ETFs dynamically adjust their baskets to correct portfolio imbalances while facilitating ETF arbitrage. Basket inclusion improves bond liquidity in general, but worsens it in periods of large imbalance between creations and redemptions, such as the COVID-19 crisis.

Keywords: ETFs, liquidity transformation, market liquidity, active management

JEL Classification: G12, G23

Suggested Citation: Suggested Citation

Koont, Naz and Ma, Yiming and Pastor, Lubos and Zeng, Yao, Steering a Ship in Illiquid Waters: Active Management of Passive Funds (February 1, 2023). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper , Available at SSRN: https://ssrn.com/abstract=4053844 or http://dx.doi.org/10.2139/ssrn.4053844