Liquidity risk and exchange-traded fund returns, variances, and tracking errors

Abstract We investigate the effect of exchange-traded fund (ETF) liquidity on ETF tracking errors, returns, and volatility in the US. We find that illiquid ETFs have large tracking errors. The effect is more pronounced when underlying assets are less liquid. Returns and liquidity of illiquid ETFs are more sensitive to underlying index returns or ETF market liquidity, or both. Thus, a positive liquidity premium exists in US ETF markets. The ETF variance could be larger than its net asst value variance owing to infrequent trading. In summary, illiquid ETFs are more likely to deviate from their underlying indexes and could be riskier than underlying portfolios.