A Four-Trillion-Dollar Question: Why Trade ETFs Instead of Their Underlying Stocks?
53 Pages Posted: 16 Mar 2012 Last revised: 8 Feb 2024
Date Written: November 8, 2023
Abstract
One potential answer is that, according to information-based theories, ETFs should be more liquid than their underlying stocks. However, this prediction does not hold for around 90% of US-equity ETFs, a four-trillion-dollar market. We hypothesize that investors value ETFs’ convenience, for which, our estimate shows, they pay 37 bps of market capitalization per annum. Consistent with our hypothesis, convenience costs are higher when there are a priori reasons for higher demand or costlier supply for convenience. Finally, larger ETFs tend to have lower convenience costs, which may help them grow even larger, leading to a fat-right-tailed size distribution among ETFs.
Keywords: Financial Innovation, ETF, Information Sensitivity, Convenience, Speculation, Leverage.
JEL Classification: G11, G23
Suggested Citation: Suggested Citation