The Effect of ETFs on Stock Liquidity

Abstract

This paper investigates whether markets for individual stocks lose liquidity when uninformed investors are given options to avoid trading against informed investors. I find a positive association between the percentage of firm shares being held by exchange-traded funds (ETFs) and illiquidity in the market for the underlying stocks. This liquidity deprivation is mitigated for stocks with high quality earnings. These results imply that investors with an informational disadvantage migrate after weighing the cost and benefits of trading portfolios versus the underlying stocks. I further examine how portfolio-level liquidity relates to diversification when liquidity dynamically flows between a portfolio and its underlying stocks.

Keywords: ETF, liquidity, adverse selection, earnings quality, diversification

JEL Classification: G11, G12, G14, M41