Exchange Traded Funds (ETFs)

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Posted by Itzhak Ben-David, The Ohio State University, on Wednesday, November 23, 2016
Editor's Note: Itzhak Ben-David is the Neil Klatskin Chair in Finance and Real-Estate at The Ohio State University’s Fisher College of Business. This post is based on a forthcoming article, submitted to the Annual Review of Financial Economics, by Professor Ben-David; Francesco Franzoni, Professor of Finance, University of Lugano (USI) and Senior Chair at the Swiss Finance Institute; and Rabih Moussawi, Assistant Professor of Finance at the Villanova School of Business.

Since the mid-1990s, exchange traded funds (ETFs) have become a popular investment vehicle due to their low transaction costs and intraday liquidity. ETFs issue securities that are traded on the major stock exchanges, and, for the most part, these instruments aim to replicate the performance of an index. ETFs have shown spectacular growth. By mid-2016, they represented about 10% of the market capitalization of securities traded on US stock exchanges. [1]

ETFs have similarities and differences relative to other pooled investment vehicles. ETFs either hold a basket of securities passively (physical replication) or enter into derivative contracts delivering the performance of an index (synthetic replication). They issue securities (mostly shares) that are claims on the underlying pool of securities. ETF shares are traded on stock exchanges, and investors can take either long or short positions. Two mechanisms keep ETF prices in line with those of the basket that they aim to track: primary and secondary market arbitrage. The first mechanism involves the creation and redemption of ETF shares by authorized participants (APs), which are the official market makers for a given ETF. When ETF prices and the prices of the underlying securities diverge, APs typically buy the less expensive asset (ETF shares or a basket of the underlying securities) and exchange it for the more expensive asset, leading to the creation or redemption of ETF shares. The second type of trade, consisting of long and short positions in the secondary market, retains some uncertainty with respect to the horizon over which price convergence will occur; thus, it is an arbitrage only in a loose sense.

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