ETFs, Illiquid Assets, and Fire Sales

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. Joint paper with John J. Shim.

Link to paper.