BONDS, INTEREST RATES, AND MARKET MICROSTRUCTURE

Question 1

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Which one - ETF or mutual fund - interacts directly with the capital markets

Answer 1

Mutual Fund. ETF does not interact with capital markets directly. ETF manager is in legal contract with Authorized Participant (large financial institutions who interacts with the market instead of them)

Question 2

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

At what prices shares trade for ETFs?

Answer 2

Trades occur at MARKET determined PRICES

Question 3

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

At what prices shares trade for mutual funds?

Answer 3

Trades occur at the end of the day at NET ASSET VALUE (NAV)

Question 4

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe and compare transaction costs for ETFs vs. mutual funds

Answer 4

ETF - externalized (because of no interaction with the capital markets) -> reduced transaction costs

Mutual Fund - Investors bear transaction costs incurred by participants

Question 5

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe and compare transparency for ETFs vs. mutual funds

Answer 5

ETF - much transparency. Investment strategies specified in advance, holdings listed daily

Mutual Funds - Less transparency. Holdings listed quarterly.

Question 6

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

In which one - ETF or mutual fund - can investors short sell, buy on margin or lend shares?

Answer 6

ETF. Mutual funds cannot do that

Question 7

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe 3 potential issues for ETFs

Answer 7

1) Investors may have POOR FINANCIAL KNOWLEDGE to distinguish between the types of ETFs (e.g. levered funds)
2) Intraday liquidity can cause “TOO MUCH” TRADING. Investors who trade actively suffer lower returns than those who trade less.

3) Rapid growth in index investing poses CHALLENGES FOR ORDINARY INVESTORS

Question 8

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe 3 types Equity ETFs

Answer 8

1) Market Capitalization based ETFs (Equity ETFs based on their SIZE)
2) Sector ETFs: track market-weighted) capitalization benchmark for a sector (e.g. real estate) (Equity ETFs based on their SECTOR)

3) Factor/smart beta ETFs: driven by the desire to outperform the market by focusing on certain factors linked to stock returns (e.g. size factor). It is a
cross between active and passive investment strategies.
(Equity ETFs based on their SMART BETA FACTOR)

Question 9

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

What are Fixed Income ETFs?

Answer 9

Portfolio of investment-grade and government BONDS. (purchased via bank loans and high-yield bonds)

Question 10

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

What are 3 reasons for the recent growth in bond ETFs?

Answer 10

1) Bond ETFs are traded on ELECTRONIC EXCHANGES – CONVENIENT (unlike opaque OTC markets for
traditional bonds)

2) Offer HIGHER TRANSPARENCY - bid/ask quotes are
readily available
3) Offer greater LIQUIDITY and DIVERSIFICATION

Question 11

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

What are Commodity ETFs?

Answer 11

A commodity ETF is an exchange-traded fund (ETF) invested in physical commodities, such as agricultural goods, natural resources, and precious metals. A commodity ETF is usually focused on either a single commodity—holding it in physical storage—or is focused on investments in futures contracts.

Commodity ETF is often viewed as a hedge against
inflation or a source of diversification.

Question 12

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the concern about closure prices of ETFs.

Answer 12

When an ETF closes, its price SHOULD converge to its NAV and underlying assets may be returned in kind (relatively safe)

HOWEVER, in case of exchange-traded unsecured debt obligations issued by Lehman Brothers in 2008, there were no underlying assets to be returned to investors when the bank declared bankruptcy

Implication: investors need to distinguish between various exchange-traded products

Question 13

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the concern around short selling of ETFs

Answer 13

May cause bankruptcy of the fund if the aggregate long and synthetic long positions exceeds the total actual number of outstanding ETF shares (number of simultaneous redemptions would exceed available assets to be redeemed)

Question 14

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the concern around securities lending by ETF

Answer 14

May pose a THREAT TO INVESTORS but it is very UNLIKELY due to the presence of different safeguards on lending of securities by ETFs. Moreover, it enhances short-selling, which leads to improved price liquidity and efficiency.

Question 15

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the potential Flash Crash of ETFs and why it may be a misconception

Answer 15

ETFs were represented among the securities most affected with prices diverging from their NAVs
– could cause the Flash Crash, yet most likely flash events are not driven by structural problems

with ETFs (e.g. a lot of trading venues, fragmented market)

Question 16

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the concern about liquidity mismatch for ETFs

Answer 16

Liquidity in the primary market refers to the ability of Authorized Participants (APs) to acquire the underlying assets and transfer them to the ETF. The chance that an AP steps away in a crisis may pose SYSTEMATIC RISK. Yet, if a particular AP stops its activities, remaining
APs continue providing liquidity. (If Diana and Dana are transacting, and Dana steps out, Katrina will take over and help Diana)

THIS IS ONLY A PROBLEM FOR SMALL ETFs WHO HAVE VERY LITTLE APs.

Question 17

Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018

Describe the concern about the impact on the underlying market (from ETFs)

Answer 17

1) Index trackers are typically based on market capitalization-weighted schemes -> pricing errors in underlying stocks might feed on themselves
2) Index funds are price-takers, not price-makers

But, the IMPACT of a “basket” security on liquidity and distortion of prices of the underlying market is UNCLEAR

However, in practical terms, the relative scale of index investing is still small (20% of global equities)

Question 18

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe the development of the number of public firms

Answer 18

The number of listed firms increases rather steadily until 1997. After that, the number starts decreasing and a “listing gap” develops (fewer firms than expected). By 2012, the predicted number of listed companies is more than double of the actual number.

(today: PREDICTED # > ACTUAL #)