Price Dynamics and Liquidity of Exchange-Traded Funds

Ananth Madhavan
Exchange traded funds (ETFs) have grown substantially in diversity, market significance and size in recent years. As a consequence, there is increased interest by practitioners in the pricing and trading of these investment vehicles. This paper develops a model to examine ETF price discovery and premium dynamics, and estimates the model individually for 947 US-domiciled ETFs in the period 2005-2014. We find that pricing efficiency varies significantly across funds and is systematically related to cross-sectional measures of liquidity. We provide an illustration of a bond ETF during the financial crisis of 2008 to highlight how apparently dramatic discounts really reflected price discovery when the underlying basket was illiquid in the extreme.