Inefficiencies in the Pricing of Exchange-Traded Funds

January 2017 (published version) (working paper)

Financial Analysts Journal, 2017, 73(1):24-54 (lead article)

Winner of INQUIRE Europe Research Grant 2010

NEW: Related video appearance on CNBC (link)

Note: The data have been fully refreshed, adding 4 more years to the earlier sample

Related research report that focuses on market-on-close transactions in ETFs (pdf file)


The prices of exchange-traded funds can deviate significantly from their net asset values, on average fluctuating within a band of about 200 basis points, in spite of the arbitrage mechanism that allows authorized participants to create and redeem shares for the underlying portfolios. The deviations are larger in funds holding international or illiquid securities where net asset values are most difficult to determine in real time. To control for stale pricing of the underlying assets, I introduce a novel approach using the cross-section of prices on a group of similar ETFs. Nevertheless, the average pricing band remains economically significant at about 100 basis points, with even larger mispricings in some asset classes. Active trading strategies exploiting such inefficiencies produce substantial abnormal returns before transaction costs, providing further proof of short-term mean-reversion in ETF prices.
Keywords: ETF, premium, discount, mispricing, arbitrage, NAV


What Is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds

September 2014 (joint with Jussi Keppo) (published version) (working paper)

Journal of Alternative Investments, 2014, 17(2):9-24


On the surface, hedge funds seem to have much higher fees than actively managed mutual funds. However, the true cost of active management should be measured relative to the size of the active positions taken by a fund manager. A mutual fund combines active positions with a passive position in the benchmark index, which can make the active positions expensive. A hedge fund takes both long and short positions and uses leverage, which makes the active positions cheaper, but this can be offset by the expected incentive fees, especially for more volatile funds. We investigate the trade-offs from the perspective of a fund investor choosing between a mutual fund and a hedge fund, examining the impact of leverage, volatility, Active Share, nominal fees, and alpha for a realistic range of parameter estimates. Our calibration shows that a moderately skilled active manager is approximately equally attractive to investors as a mutual fund manager or as a hedge fund manager, showing that both investment vehicles can coexist as efficient alternatives to investors. Further, our model explains documented empirical findings on career development of successful fund managers and on hedge funds' risk taking. Finally, we show that our findings are quite robust with respect to a jump risk in the hedge fund returns.
Keywords: Management fee, incentive fee, hedge fund, mutual fund


Global Return Premiums on Earnings Quality, Value, and Size (pdf file)

November 2012 (joint with Max Kozlov)


We investigate the return premium on stocks with high earnings quality using a broad and recent global dataset covering all developed markets from 7/1988 to 6/2012. We find that a simple strategy that is long stocks with high earnings quality and short stocks with low earnings quality produces a higher Sharpe ratio than the overall market or similar strategies betting on value or small stocks. This result holds both in the overall sample as well as in the more recent time period since 2005. Because the global earnings quality portfolio has a negative correlation with a value portfolio, an investor wishing to invest in both exposures can achieve significant diversification benefits.
Keywords: Earnings quality, value, international, accruals


Active Share and Mutual Fund Performance

July 2013 (published version) (working paper)

Financial Analysts Journal, 2013, 69(4):73-93

Winner of the Graham and Dodd Scroll Award

NEW: Official FAJ response to AQR's article on Active Share, July 2016 (link)

Selected media coverage

Click here for data on Active Share of mutual funds


I sort domestic all-equity mutual funds into different categories of active management using Active Share and tracking error. I find that over my sample period until the end of 2009, the most active stock pickers have outperformed their benchmark indices even after fees and transaction costs. In contrast, closet indexers or funds focusing on factor bets have lost to their benchmarks after fees. The same long-term performance patterns held up over the 2008-2009 financial crisis, and they also hold within market cap styles. Closet indexing increases in volatile and bear markets and has become more popular after 2007. Cross-sectional dispersion in stock returns positively predicts average benchmark-adjusted performance by stock pickers.
Keywords: Active Share, tracking error, closet indexing


Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation

July 2013 (joint with Martijn Cremers and Eric Zitzewitz)

(published version) (working paper)

Critical Finance Review, 2013, 2:1-48 (lead article)

Winner of the Commonfund Best Paper Prize at the EFA 2009 Annual Meeting

Winner of the Best Paper Award at the FMA 2009 European Conference

Winner of the Roger F. Murray Best Paper Prize (3rd place) at the Q-Group 2009 conference

Winner of Q-Group Research Grant 2007

NEW: Click here for return data on index-based factors


Standard Fama-French and Carhart models produce economically and statistically significant nonzero alphas even for passive benchmark indices such as the S&P 500 and Russell 2000. We find that these alphas primarily arise from the disproportionate weight the Fama-French factors place on small value stocks which have performed well, and from the CRSP value-weighted market index which is historically a downward-biased benchmark for U.S. stocks. We explore alternative ways to construct these factors and propose alternative models constructed from common and easily tradable benchmark indices. The index-based models outperform the standard models in common applications such as performance evaluation of mutual fund managers.
Keywords: Benchmarking, factor models, portfolio management


How Active Is Your Fund Manager? A New Measure That Predicts Performance

September 2009 (joint with Martijn Cremers) (published version) (working paper)

Review of Financial Studies, 2009, 22(9):3329-3365 (lead article)

Winner of the Best Paper Award at the Financial Research Association 2006 Annual Meeting

Top 100 most downloaded paper on SSRN across all time and disciplines
Related op-ed piece: "Magellan's Problem: Closet Indexing," November 15, 2005 (pdf file)

Selected media coverage

Click here for data on Active Share of mutual funds


To quantify active portfolio management, we introduce a new measure we label Active Share. It describes the share of portfolio holdings that differ from the benchmark index. We determine the type of active management for a portfolio by measuring it in two dimensions using both Active Share and tracking error volatility. We apply this approach to the universe of all-equity mutual funds to characterize how much and what type of active management they practice. We test how active management is related to fund characteristics such as size, expenses, and turnover in the cross-section, and we examine the evolution of active management over time. Active management also predicts fund performance: funds with the highest Active Share significantly outperform their benchmark indexes both before and after expenses, and they exhibit strong performance persistence even after controlling for momentum. Non-index funds with the lowest Active Share underperform.
Keywords: Portfolio management, Active Share, tracking error, closet indexing


Why Do Demand Curves for Stocks Slope Down?

October 2009 (published version) (working paper)

Journal of Financial and Quantitative Analysis, 2009, 44(5):1013-1044 (lead article)

An earlier and more comprehensive version, including results on endogeneously arising institutions and optimal institutional structure (pdf file)

Separate appendices: Empirical tests (pdf file) and a more elaborate model (pdf file)


Representative agent models are inconsistent with existing empirical evidence for steep demand curves for individual stocks. This paper resolves the puzzle by proposing that stock prices are instead set by two separate classes of investors. While the market portfolio is still priced by individual investors based on their collective risk aversion, those individual investors also delegate part of their wealth to active money managers who use that capital to price stocks in the cross-section. In equilibrium the fee charged by active managers has to equal the before-fee alpha they earn; this endogenously determines the amount of active capital and the slopes of demand curves. A calibration of the model reveals that demand curves can indeed be steep enough to match the magnitude of many empirical findings, including the price effects for stocks added to (or deleted from) the S&P 500 index.
Keywords: Demand curves for stocks, delegated portfolio management, equilibrium mispricing, index premium


The Index Premium and Its Hidden Cost for Index Funds

March 2011 (published version) (working paper)

Journal of Empirical Finance, 2011, 18(2):271-288


This paper empirically investigates the index premium and its implications from 1990 to 2005. First, we find that the price impact has averaged +8.8% and +4.7% for additions to the S&P 500 and Russell 2000, respectively, and -15.1% and -4.6% for deletions. The premia have been growing over time, peaking in 2000, and declining since then. Second, the implied price elasticity of demand increases with firm size and decreases with idiosyncratic risk, supporting theoretical predictions. Third, we introduce a new concept that we label the index turnover cost, which represents a hidden cost borne by index funds (and the indexes themselves) due to the index premium. We illustrate this cost and estimate its lower bound as 21-28bp annually for the S&P 500 and 38-77bp annually for the Russell 2000.
Keywords: Index premium, index turnover cost, index fund, S&P 500, Russell 2000


Selection of an Optimal Index Rule for an Index Fund (pdf file)

August 2008

Journal of Financial Markets, revise and resubmit


Several empirical studies document a substantial price premium for stocks in the S&P 500 index. For index investors this creates a recurring cost: as the index is updated, they need to buy stocks with the premium and sell stocks without the premium. Different index rules can produce different index premia due to the different frequency and criteria of updating. We build a model to investigate the behavior of the index turnover cost and the portfolio performance of a mechanical index fund under a market-cap rule, an exogenous random rule, and a deterministic rule. We find that the rational anticipation of future index composition reflected in prices today eliminates any first-order differences in index fund performance across the three index rules. As the index investors become a large part of the market, the non-index investors become less diversified, and this induces hedging motives which hurt the index investors especially under a market-cap rule.
Keywords: Index premium, index turnover cost, index fund, S&P 500, Russell 2000





Hedge Funds, Mutual Funds, and ETFs

(joint with Stephen Brown and Anthony Lynch)

Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, ed. by Acharya et al., Wiley, 2010, chapter 12:351-366





Treasury Bond Supply and Demand under Fed Tapering (article)

June 2013


Many market participants expect Treasury bonds to collapse once the Fed ends its QE program because the Fed has been such a large buyer. However, I find that this scenario is highly unlikely: the combination of rapidly declining Federal deficits and persistently large purchases by the foreign official sector mean that the private sector will not have to start buying new long-term Treasury bonds even after the Fed ends QE.


Who Has Been Buying U.S. Treasuries? (pdf file)

March 2012


When evaluating the impact of Treasury bond supply on long-term rates, most market observers seem to have overlooked two key issues: the large role of the foreign official sector (it is not all about the Fed), and the distinction between all Treasuries vs. only long-term Treasuries. Despite large issuance due to the $1.3 trillion federal budget deficit, private investors were actually net sellers of long-term Treasuries in 2011.





Mauboussin, Michael: "Seeking Portfolio Manager Skill," Legg Mason investment strategy report, February 24, 2012


"Mutual Fund Investors Should Crack Down on Closet Indexers," Bloomberg, February 8, 2012


Laise, Eleanor: "Can Anyone Steer This Ship?" The Wall Street Journal, April 23, 2011


Lallos, Laura: "What You Need to Know about Active Fund Managers," Money Magazine, April 8, 2011


"Active Share: Predicting Alpha and Risk," Wellington Management Solutions, April, 2011


Byrt, Frank: "Top Stocks Picked by S&P 500 Slayers," The Street, March 16, 2011


Morgan, Sarah: "When Fund Managers Fake It," SmartMoney Magazine, February 28, 2011


Laise, Eleanor: "The Return of the Market-Beating Fund Manager," The Wall Street Journal, December 18, 2010


Korteila, Maria: "Volatiliteetti tekee salkunhoitajista vellihousuja," Arvopaperi, December 1, 2010 (in Finnish)


Lee, Samuel: "The Hidden Costs of Indexing," Morningstar, October 27, 2010


"Closet Indexers Make Up One Third of Fund Assets," Reuters TV, October 25, 2010


"SEC Regulation, Volatility Drive Closet Indexing Trend," Reuters TV, October 25, 2010


Leggio, Ryan, and John Coumarianos: "Go Active or Go Home," Morningstar, September 6, 2010


Elston, Peter: "Don't Tar All Actives with the Same Brush," Financial Times, May 30, 2010


Boucher, Christopher, and Bertrand Maillet: "Case for Active Management Is Actually Strong," Financial Times, May 2, 2010


"Closet Index Funds Are Doomed to Underperform," Fidelity Perspective, May, 2010


Whitehead, Marcus: "Genuine Active Managers Can Add Value," Financial Times, January 10, 2010


Mamudi, Sam: "What Are You Paying For?" The Wall Street Journal, December 8, 2009


Little, Pat: "Active versus Passive Equity Managers: Using the "Active Share" Measure," Hammond Associates research note, August, 2009


Solow, Ken: "Compelling Evidence that Active Management Really Works," Advisor Perspectives, June 23, 2009


Laise, Eleanor: "As Firms Boost Analyst Ranks, Here's How to Sort Out Funds," The Wall Street Journal, November 5, 2007


"A Lesson in Pursuing Alpha and Beta," Financial Times, July 23, 2007


Strauss, Lawrence: "When Divergence is Good," Barron's, July 23, 2007


Gangahar, Anuj: "Advantages of Active Investing," Financial Times, July 9, 2007


Marquardt, Katy: "Spot Closet Indexers," Kiplinger.com, July 9, 2007


Wherry, Rob: "Is Your Fund a Closet Indexer?" SmartMoney.com, May 3, 2007


Richards, Matthew: "There Are a Few Skeletons Lurking in the Closets," Financial Times, February 10, 2007


Davis, Jonathan: "A Nugget to Please Active Managers," Financial Times, February 5, 2007


Petajisto, Antti: "How Active Is Your Fund Manager?" Global Investor Magazine, November 2006


Heiskanen, Mirva: "Kaappi-indeksi laskuttaa tyhjästä," Talouselämä, November 6, 2006 (in Finnish)


Wheleham, Barbara: "Index Funds: A Good Driver of Investment Returns," Bankrate.com, October 4, 2006


O'Brian, Elizabeth: "How Active Is Your Fund Manager?" Financial Planning, October 1, 2006


Brown, Jeff: "Indexing Brings Peace of Mind to Mutual Funds," The Philadelphia Inquirer, September 5, 2006


Möttölä, Matias: "Aktiivisimmat menestyvät," Helsingin Sanomat, September 3, 2006 (in Finnish)


Hanson, Tim: "A Warning for Investors," The Motley Fool, August 30, 2006


Mossman, Laura: "Alpha Superheroes," Financial Times Investment Adviser, August 23, 2006


"Yale Study: A Third of Mutual Funds Are 'Closet Indexers,'" Institutional Investor, August 22, 2006


"More Actively Managed Funds Tied to Indexes," Money Management Executive, August 21, 2006


Lauricella, Tom: "Professors Shine a Light into 'Closet Indexes,'" The Wall Street Journal, August 18, 2006


"Index Hugging," Financial Times Investment Adviser, July 31, 2006


"Research Sorts Index Huggers from Active," Financial Times Investment Adviser, July 31, 2006


Montier, James: "Come Out of the Closet, or, Show Me the Alpha," Dresdner Kleinwort Global Equity Strategy research report, July 19, 2006





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