The Effect of ETFs on Stock Liquidity

51 Pages Posted: 8 Oct 2010 Last revised: 23 Apr 2014

Sophia J. W. Hamm

Ohio State University (OSU) - Fisher College of Business

Date Written: April 23, 2014

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

Suggested Citation

Hamm, Sophia J. W., The Effect of ETFs on Stock Liquidity (April 23, 2014). Available at SSRN: https://ssrn.com/abstract=1687914 or http://dx.doi.org/10.2139/ssrn.1687914

Sophia J. W. Hamm (Contact Author)

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-2529 (Phone)

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