The ETF concept could be interesting to look at. I was reading Tryenor's book and I thought he mentioned how entering an ETF position still nets out below an index return because of the cost of liquidity.
I wonder if ETFs would have ever grown as large as they had if HFT never existed (the time periods of the rise of ETF parallels to the rise of HFT.) Anybody have any insight here?
The success of ETFs is probably significantly underwritten by the increased liquidity. As a rule of thumb liquidity makes markets less volatile and thus able to sustain more complex structures.
ETFs control tracking error, how closely the ETF follows the index to which it is benchmarked, by letting authorised participants (APs) arbitrage the ETF against the underlying. For example, if you are a SPY AP, you can turn in a certain quantity, called the creation unit, of S&P 500 constituent stocks and "create" the correct number of ETF units. Alternatively, you could surrender a creation unit of SPYs and the ETF trust would "destroy" those ETF units and issue you the S&P 500 constituent stocks [1].
The risk for APs increases non-linearly vis-a-vis the liquidity of the underlying. This has been empirically witnessed as a "U-shaped relationship between fund premium and market liquidity, which suggests that more active trading does lead to lower mispricing but only after a certain level of liquidity is reached" [2].
I wonder if ETFs would have ever grown as large as they had if HFT never existed (the time periods of the rise of ETF parallels to the rise of HFT.) Anybody have any insight here?