51 Pages Posted: 8 Oct 2010 Last revised: 23 Apr 2014
Date Written: April 23, 2014
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
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