Do ETFs Increase the Commonality in Liquidity of Underlying Stocks?

Abstract

We examine the impact of ETF ownership on the commonality in liquidity of underlying stocks, while controlling for other institutional ownership. Analyses using aggregate stock-level ETF ownership and common ETF ownership at the stock-pair level indicate that ETF ownership significantly increases commonality. We show that greater arbitrage activities are associated with a larger effect of ETF ownership on commonality. We use quasi-natural experiments that exploit the reconstitution of Russell indexes, and ETF trading halts, to establish the causal effect of ETF ownership and the arbitrage mechanism, respectively. Our results suggest that ETFs reduce investors' ability to diversify liquidity risk.

Keywords: Exchange traded funds, commonality in liquidity, authorized participants, arbitrage, institutional ownership, trading halts, index reconstitution, liquidity risk

JEL Classification: G20, G23