Canadian Investment Review

The dark side of ETFs?

Written by Caroline Cakebread on Wednesday, August 19th, 2015 at 8:59 am

moon dark_edited-1Earlier this year exchange-traded funds (ETFs) hit a major milestone: at US$2.97 trillion, ETF assets surpassed hedge fund assets as investors showed their preference for cheap and liquid exposure to passive indices. The question is, what is it doing to capital markets? And as investors seek out market access at a low cost, are they unwittingly pushing up the cost of investing at the same time? A new paper by a group of academics finds that ETFs’ growing popularity is leading to some unwanted side effects—higher trading costs and less analyst coverage for stocks with high ETF ownership.

The paper, “Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective,” comes from Stanford University and is authored by Doron Israeli, Charles M.C. Lee and Suhas A. Sridharan.

The authors’ overall finding is that, as investors shift to broad coverage through an ETF and away from trading directly in certain stocks, the markets are changing in some not-so-subtle ways. As ETFs become larger holders of individual firm’s shares, transaction costs for the underlying securities goes up because there is decreased available liquidity for securities owned by the ETF. Those higher transaction costs cause a deterioration in the pricing efficiency of the underlying securities. As that happens, the desire for information about those stocks declines—fewer analysts end up covering them and, as a result, the “information environment” deteriorates making it harder to get good information on those stocks. Markets, then, are unable to reflect firm-specific information in a timely manner.

A few specific findings from the paper:

The research is interesting and worth further consideration. As ETFs continue to democratize markets, offering access to more and more investors, we do need to understand the implications for the underlying stocks and the overall market. At the same time, as ETFs evolve into new areas (i.e., fixed income) I wonder if they might have the opposite effect across different asset classes. Some institutions for instance believe that bond ETFs actually improve liquidity and reduce bid-ask spreads. It would be good to see more in-depth research on ETFs and their effects on capital markets especially as they become a larger part of the institutional toolkit.

Download the paper here.

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