The Effect of ETFs on Stock Liquidity

Abstract:     
Prior studies suggest that when uninformed investors trade exchange-traded funds (ETFs) in order to avoid trading against informed investors, markets for individual stocks lose liquidity and ETF markets gain liquidity. I find a positive association between a higher percentage of firm shares held by ETFs and liquidity in the market for stocks, especially for those held by highly diversified ETFs. As a result, highly diversified ETFs benefit more from liquidity inflow than sector ETFs. However, diversified ETFs suffer more from underlying stock illiquidity. This dynamic casts doubt on whether uninformed investors can effectively avoid adverse selection cost by trading ETFs.

Number of Pages in PDF File: 57

Keywords: ETF, mutual fund, liquidity, information asymmetry, adverse selection, index

working papers series