Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective

Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective

By Doron Israeli, Charles M. C. Lee, Suhas A. Sridharan
July 26,2015Working Paper No. 3322

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.

Keywords
Exchange Traded Funds (EFTs), Uninformed and Informed Traders, Costly Information, Trading Costs, Pricing Efficiency