A Three-Trillion-Dollar Question: Why Trade ETFs Instead of Their Underlying Assets?

Abstract

One potential answer is that, according to information-based theories, ETFs should be more liquid than their underlying assets. However, this prediction does not hold for over 90% of US equity ETFs. We propose a “convenience” hypothesis: investors trade ETFs partly for convenience, for which, we estimate, they pay an annual intermediation cost of over 2% of the market capitalization. Consistent with our convenience hypothesis, this cost is higher for ETFs with more volatile underlying indexes; prior to index reconstitutions; or for leveraged ETFs, whose intermediation cost increased drastically during the Global Financial Crisis, exceeding 10% per month in late 2008.