We study arbitrage in ETFs holding illiquid corporate bonds, focusing on authorized participants (APs) and their balance sheet space constraints. As unique ETF arbitrageurs, most APs are also bond dealers, and they use their own balance sheet in both roles. We find that bond market illiquidity...

Index-tracking fixed-income ETFs have experienced an explosive growth spurt to reach $1 trillion in 2020. However, they suffered significant disruptions during the Covid-19 crisis. We show that bank balance sheet constraints were likely a contributing factor to these disruptions because bond...

A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs...

A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs...

Exchange-traded funds (ETFs) are typically viewed as passive index trackers. In contrast, we show that corporate bond ETFs actively manage their portfolios, trading off index tracking against liquidity transformation. In our model, ETFs optimally choose creation and redemption baskets that...