Is There A Dark Side To ETFs? An Information Perspective

Doron Israeli

Interdisciplinary Center (IDC) Herzliya – Arison School of Business

Charles M.C. Lee

Stanford University – Graduate School of Business

Suhas A. Sridharan

University of California, Los Angeles

July 26, 2015

Stanford University Graduate School of Business Research Paper No. 15-42

Abstract:

In a noisy rational expectations framework with costly information, some agents expend resources to become informed, and earn a return for their efforts by trading with the uninformed. Applying this insight, we examine the proposition that an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component securities. Our tests show an increase in ETF ownership is associated with: (1) higher trading costs (measured as bid-ask spreads and price impact of trades); (2) an increase in “stock return synchronicity” (measured as the co-movement of firm-level stock returns with general market and related-industry stock returns); (3) a decline in “future earnings response coefficients” (measured as the predictive power of current returns for future earnings), and (4) a decline in the number of analysts covering the firm. Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition, a combination which results in less informative security prices for the component firms.

Is There A Dark Side To Exchange Traded Funds (ETFs)? An Information Perspective – Introduction

Traditional noisy rational expectations models with costly information feature agents who expend resources to become informed. These informed agents earn a return on their information acquisition efforts by trading with the uninformed, and as they do so, the information they possess is incorporated into prices.1 In these models, the supply of uninformed traders adjusts to provide just sufficient reward for costly efforts in information acquisition and processing. The equilibrium between cost constraints faced by informed traders and gains from trading against the uninformed is reflected in the level of informational efficiency of security prices in the market. The inherent tension between the efficiency with which firm-specific information is being incorporated into stock prices, and the incentives needed to acquire that information and disseminate it, is central to understanding the informational content and role of security prices (e.g., Hayek 1945, Grossman 1989).

In this paper, we use a natural experiment to examine the economic linkages between the market for firm-specific information, the market for individual securities, and the role of uninformed traders. Specifically, we study the influence of exchange-traded fund (ETF) ownership on the pricing efficiency (or “price informativeness”) of the individual component securities underlying the fund.2 In frictionless markets, a firm’s ownership structure should have little to do with the informativeness of its share price. However, as we argue below, market frictions related to information acquisition costs can cause ownership by ETFs to be a significant economic event, with direct consequences for price informativeness in the underlying securities.

Our central conjecture is that ETF ownership can influence a stock’s price informativeness through its impact on the supply of underlying securities available for trade, as well as the number of uninformed traders willing to trade these securities. As ETF ownership grows, an increasing proportion of the outstanding shares for the underlying security becomes “locked up” (held in trust) by the fund sponsor. Although these shares are available for trade as part of a basket transaction at the ETF-level, they are no longer available to traders who wish to transact on firm-specific information. In addition, ETFs offer an attractive investment alternative for uninformed traders who would otherwise trade the underlying component securities.3 These two effects create a steady siphoning of firm-level liquidity which in turn generates a disincentive for informed traders to expend resources to obtain firm-specific information.

ETFs

ETFs

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