The Dark Side of ETFs?

Sounds interesting, and in my humble opinion, an image of Darth Vader on page 1 would be a great addition to the paper.

The paper, “Is there a dark side to exchange traded funds? An information perspective,” written by Doron Israeli, Charles M. C. Lee, and Suhas A. Sridharan, digs into the details on some implications of higher ETF ownership on individual stocks.

The main premise of the paper is as follows–more people are investing using ETFs, so what are the implications of higher ETF ownership for individual stocks?

Wes recently wrote a summary of a theory paper on this exact topic for etf.com. An interesting fact from the theory paper is the following (quoted from the paper):

We find that after introducing composite securities with endogenous designs, asset prices reflect more systematic information and less asset-specific information, because market makers, understanding that the factor speculator now fully exploits his informational advantage, set prices more sensitive to the composite security orders.

The theory paper suggests that systematic information becomes important (as ETF ownership grows) and firm-specific information becomes less important. Very interesting!

So while the theory says that ETFs are causing firm-specific information to have less of an impact, what does the data say? That is the point of this paper we will discuss below.

Paper Hypotheses

The paper begins by proposing that there are two ways that increased ETF ownership can affect individual stocks.

We propose and test two hypotheses. First, we posit that as ETFs become larger holders of a firm’s shares, trading costs for the underlying securities will increase. This increase in trading costs is associated with a decrease in available liquidity for the component securities owned by ETFs. Second, we posit that the increased trading costs will lead to a general deterioration in the pricing efficiency of the underlying securities. Specifically, we posit that the increased trading costs will deter traders who would otherwise expend resources on information acquisition about that stock. In other words, for firms that are widely held by ETFs, the incentive for agents to seek out, acquire, and trade on firm-specific information will decrease. Over time, this will result in a general deterioration in the firm’s information environment and a reduction in the extent to which its stock price can quickly reflect firm-specific information

So the papers is proposing two hypotheses: