A Four-Trillion-Dollar Question: Why Trade ETFs Instead of Their Underlying Stocks?

Abstract

One 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 are attracted to ETFs for convenience. Consistent with this hypothesis, our estimated convenience costs are higher when there are a priori reasons for higher demand or costlier supply for convenience. Larger ETFs tend to have lower convenience costs, which may help them grow further. This positive feedback loop might have contributed to the rapid ETF market expansion and the highly skewed cross-sectional size distribution.

Keywords: Financial Innovation, ETF, Information Sensitivity, Convenience, Speculation, Leverage., Positive Feedback Loop, Increasing Returns to Scale

JEL Classification: G11, G23