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

Naz Koont, Yiming Ma, Pástor, Luboš and Yao Zeng
Authors registered in the RePEc Author Service: Lubos Pastor

No 17283, CEPR Discussion Papers from Centre for Economic Policy Research

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. 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.

JEL-codes: G12 G23 (search for similar items in EconPapers)
Date: 2022-05
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Working Paper: Steering a Ship in Illiquid Waters: Active Management of Passive Funds (2022)
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