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13 December 2019 Financial Analysts Journal Book Review

Exchange-Traded Funds and the New Dynamics of Investing (a review)

  1. Janet J. Mangano
This comprehensive study of the structure, price dynamics, and valuation of exchange-traded funds (ETFs) addresses their current uses in various investment settings. It attributes the rapid growth of ETFs to factor-based investing and the rise of robo-advisers. The book is a fascinating deep dive into all categories of ETFs, including equity, fixed income, foreign currencies, and alternative investments, with a particular focus on issues of tracking and liquidity.

Exchange-Traded Funds and the New Dynamics of Investing addresses topics of interest to almost all investors—namely, the rise of passive investing and the rapid growth of exchange-traded funds (ETFs). The book demonstrates through numerous examples that passive investing involves active choices and that individual investment selection to achieve portfolio goals within established risk parameters clearly has a place in passive investing.

The book tackles a multipronged mission: to provide an understanding of the structure of ETFs, to show how they differ from index mutual funds, to detail how they perform in stressed markets, to illustrate how to use them in active strategies, and to deal with public policy questions related to systemic risk and the impact of passive flows on underlying markets.

The book is neatly divided into five parts. The chapters are well-structured and documented, with plenty of interesting sidebars, together with graphs and tables. Each chapter delivers clear lessons that readers will want to take notes on. Author Ananth Madhavan, a practitioner with an extensive background in business and academia, enriches the text with technical and mathematical passages. He indicates that the reader may skip these, but I disagree. I consider this material essential to understanding important concepts, such as deviation of the ETF price from net asset value (NAV), autocorrelation, tracking error and tracking difference, and even diversification.

“Passive Investing” (Part I) describes the investment landscape in light of the rise of indexing and highlights the importance of benchmarking. The discussion of ETF structures and mechanics deals with frequently overlooked matters, such as the role of authorized participants, the creation/redemption mechanism, the arbitrage that underscores the difference between value and price, in-kind transactions, and tax efficiency. Other than tax efficiency, these topics are all critically important to both institutional and individual investors. Impressive graphics enable the reader to understand the ETF creation and redemption mechanisms and differentiate between the open-end and closed-end fund architectures. Part I also highlights important nomenclature. For example, the author discusses exchange-traded notes (ETNs), which are senior unsecured debt securities with their own special risks, and uses the unforgettable example of the Lehman Brothers Opta ETNs as an illustration.

In “Valuation, Pricing, and Trading” (Part II), Madhavan develops and unfolds his model of ETF price dynamics, which is based on the arbitrage mechanism unique to ETFs. He shows how premiums and discounts can be decomposed into price discovery and transitory liquidity components. Price discovery is key to valuation, especially during times of market stress and even on market holidays when NAVs are stale. Madhavan shows that an ETF’s unit size proves to be a critical influence on liquidity, tracking error, and costs for ETF managers, suggesting that bigger is better for ETF managers and investors. He also addresses primary and secondary market liquidity at length and shares a number of interesting facts about the size of average daily aggregate creations and redemptions that provide a sense of scale to primary and secondary market ETF trading.

“Applications” (Part III) focuses on the advantages and goals of using ETFs by user type—that is, individual (for tax and cost efficiencies) and institutional (for cash management, portfolio completion strategies, transition management, low-cost shorting and hedging, and tactical trading). ETFs allow investors to obtain long or short exposures quickly without relying on derivatives—with the added benefits of excellent liquidity and low costs. Madhavan provides rich examples and explanations for ETF investing in foreign currencies, commodities, alternatives, multiasset strategies, and volatility, but the most revealing and educational section deals with fixed income.

Fixed-income ETFs have grown rapidly since 2009 despite liquidity challenges arising from post-financial-crisis regulations. Nevertheless, fixed-income ETFs still amount to a tiny fraction of all ETFs and of the global fixed-income market. The reason is partly that transaction costs for bond ETFs are higher than they are for equity ETFs and partly that premiums and discounts in bond ETFs create confusion about how ETFs operate. Madhavan offers compelling evidence that economically significant discounts/premiums often reflect price discovery by the ETF, combined with relatively slow adjustment of NAVs. The fixed-income section could serve as the foundation of future work on the effects on bond pricing of rising interest rates, increased issuances (perhaps of US Treasury securities and municipal bonds), credit-quality changes, and defaults.

“Active Strategies” (Part IV) includes two sections—one on alpha strategies and one on deviations from market-capitalization weights based on considerations other than alpha. This part highlights the key differences between ETFs and such active structures as hedge funds, and it covers restrictions that dictate the kinds of assets ETFs may hold and the types of strategies they may pursue. Madhavan compares and contrasts hedge funds and ETFs in terms of concentration of holdings, use of leverage, ability to short, holdings of illiquid assets, turnover, and disclosure of holdings. This part is also a good checkpoint to evaluate how well the reader understands what is going on, and it underscores the ideal fit between factor investing and ETFs.

Finally comes “Public Policy, Regulation, and Systemic Risk” (Part V). Although these subjects constitute the book’s last part, some practitioners may want to read this section first because it addresses the potential or imagined systemic risk posed by ETFs. This part also reveals how flows of funds provide evidence regarding investor sentiment. Madhavan asks a number of realistic policy questions while suggesting courses of action for regulators and self-governing investor groups. Additionally, he investigates the causes of the ETF settlement failures during the “Flash Crashes” of 6 May 2010 and 24 August 2015. The concluding chapter in this part, “Future Opportunities,” offers a bright outlook for the sector as the use of ETFs increases. This growth is partly the result of the growing use of technology and analytics in investing but also a reflection of the fact that ETFs can be used to fulfill investment goals of factor investing that go beyond simple benchmarking.

Exchange-Traded Funds and the New Dynamics of Investing is an essential reference and a thought-provoking commentary for professional investors in all asset classes. It takes readers out of their comfort zone and shows how the most complex investment strategies can use ETFs. Readers will be able to incorporate what they learn from reading the book into immediate practice, either through modeling and backtesting or through actualactive investing using passive instruments.

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