3 Questions: Exchange Traded Funds and Market Efficiency

Exchange traded funds (ETFs) have grown in popularity as a tool for targeting specific groups of investments all at once: A share in an ETF represents a fractional claim to a specified “basket” of financial assets. Maureen O’Hara, with co-authors Shiyang Huang and Zhuo Zhong, investigated how ETFs may affect the market for their underlying assets. Their findings suggest that industry ETFs, those which target a specific industry, improve market efficiency by allowing informed traders to hedge their risks when taking large positions in specific companies.

What role are ETFs playing in the market amid COVID-19 and the related economic uncertainty?

University of Virginia Darden School of Business Professor Richard Evans spoke with Maureen O’Hara from Cornell’s S.C. Johnson College of Business to learn more.

Q: Your paper focuses on how industry ETFs play a special role in price discovery across markets. COVID-19 has led to some large price adjustments; do you think that ETFs are helping with price discovery or are they just enhancing the ability of traders to panic?

A: There's no question that price discovery has shifted to many of the ETFs, particularly industry ETFs. They really do give you an ability to capture what's going on in the market. It’s an interesting time right now. As we look more broadly at bond ETFs, there's no question that they have struggled in the last couple of weeks. Part of the challenge is that we’ve seen big gaps between the bond ETF price and the net asset value of the fund: Gaps that are sometimes 5 and 6 and 7 percent — that is not supposed to happen. In bonds, the ETF prices are generally the better price, as the bonds underlying the ETF could be stale. Is the ETF price creating problems for markets? Do investors see the ETF and say “I'm out of here,” which then puts more pressure on the underlying bond markets, which are illiquid anyway? This can build more problems, and I think we saw some evidence of that when the Fed stepped in, in what was a first-ever announcement that they would support the broad bond market. It reflected the unusually fragile nature the bond market exhibited in March of this year.

Q: Your paper offers a great explanation for why a hedge fund or an informed trader might use an industry ETF. Why would a passive investor choose to hold an industry ETF rather than the broad market?

A: I think one of the things that we have to understand is that many ETFs are now actually active investments in many ways — they’re not just passive investments anymore. If you want to hold the Standard & Poor's Depositary Receipts (SPY) or iShares Core S&P 500 ETF (IVV) or some of the gigantic passive funds, then you are holding the whole market. That’s great, but there are now over 5,000 ETFs, and they range from the giant passive to ones that are specially designed, such as a whiskey and spirits ETF! Why do they do that? Because ETFs can be active in form and they can be active in function — so if you want to think about form, you may say, “Why would I buy an industry ETF?” Well maybe I think that there’s alpha in an industry and I believe  that the industry is undervalued. You may also have a different view, one in which you want to build a factor portfolio and use ETFs as the building blocks. In this setting, industry ETFs are perfect building blocks. Now you don't need to build your portfolio with individual stocks; you can build it with individual ETFs.

Q: You show in your paper that ETF short selling helps improve market efficiency. While ETFs can always be borrowed and short sold like stocks, there is an additional mechanism through which authorized participants create ETF shares to lend. Are there different implications for short selling depending on whether the shorted shares are created to lend?

A: The reason ETFs can get 300 percent short interest is because of the creation-redemption process. In a normal stock there’s only so much stock. If 98 percent of it is shorted, good luck trying to cover your short. If you have an ETF, it’s like the old Doritos commercial: If you like it, we will make more. Authorized participants can just create more ETF shares, and that’s what allows industry ETFs to sometimes have these huge short-positions.  

Finally, let me say that I am not a fan of leveraged ETFs. I think the number of people for whom leveraged ETF makes sense is very small. Having said that, I’m actually a big fan of ETFs [in general]: I think that they’re an ingenious product, but this creation and redemption process only works if you can actually buy the ETFs and redeem the underlying shares. One of the things we see when the when the bond prices gap out, or suddenly and strongly shift: You want to buy low and sell high. So when the underlying bond prices are high and the ETF price is low, you buy the ETF, turn it in and get the bonds — but that's when Vanguard and others say, “We're not doing that.” It’s a real challenge, and they certainly are not going to give the cash for it, so it’s a very interesting situation.

Maureen O’Hara co-authored “Innovation and Informed Trading: Evidence from Industry ETFs” with Shiyang Huang of the University of Hong Kong and Zhuo Zhong of the University of Melbourne.

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This article was developed with the support of Darden’s Richard A. Mayo Center for Asset Management, at which Michael Farrell is a postdoctoral research associate.