The Impact Of ETFs On Market Efficiency

By the end of 2018, the amount of assets in exchange-traded funds (ETFs) had passed $6 trillion. The growth in assets has led to many questions about how ETFs are impacting market liquidity, comovement of stocks and market efficiency. Lawrence Glosten, Suresh Nallareddy and Yuan Zou , authors of the September 2019 study ” ETF Activity and Informational Efficiency of Underlying Securities,” contribute to the literature by investigating the effect of ETFs’ activity on the short-run informational efficiency of their underlying securities. Their data sample covered the period January 2004 to December 2013. Following is a summary of their findings:

ETF activity increases the informational efficiency by improving the link between short-run fundamentals and stock prices. Specifically, firms with more ETF activity reflect incrementally more earnings information in their current stock returns. There was significantly improved short-run informational efficiency among small firms (firms with market capitalization below the NYSE 50th percentile) and stocks with low analyst following (firms with analyst following below the 75th percentile). In contrast, there was no such improvement for big firms and stocks with high analyst following. ETF activity results in prices that reflect systematic information in a timely manner rather than idiosyncratic earnings information, resulting in increased short-run informational efficiency. Decomposing earnings into their systematic and firm-specific components, they found that the commonality component explains the increase in short-run informational efficiency but not the idiosyncratic firm-level earnings. ETF activity is associated with the well-documented post-earnings announcement drift (PEAD) strategy returns. Specifically, the difference in five-factor adjusted returns to the PEAD strategy between low and high ETF activity is 0.88%, and it is statistically significant at the 1% level, suggesting that ETF activity incorporates information quickly into stock prices. This results in lower PEAD strategy returns as ETF activity increases. ETF activity is positively related to securities lending. The result may be a reduction in the cost of shorting, reducing the problem of limits to arbitrage that can allow anomalies to persist. The documented increase in comovement of stocks within an index linked to ETF activity can be partially explained by systematic fundamental information being incorporated in a timelier manner. ETF activity does not predict future earnings and stock returns- it merely incorporates news from different information sources into stock prices in a timely manner.

The authors also noted that research has shown that stocks that experience an increase in passive index ownership are associated with greater public scrutiny and enhanced corporate governance. These factors could increase the informational efficiency of stocks as passive ownership increases.

Summary

Glosten, Nallareddy and Zou demonstrated that ETF activity increases the short-run informational efficiency of underlying stocks, particularly for smaller firms and firms with less analyst coverage, by incorporating systematic accounting information into stock prices in a timely manner. In contrast, they found no such effect for firms with stronger information environments. They concluded: “By documenting the effect of ETF activity on the informational efficiency of the underlying stocks, we provide evidence in support of the long-standing prediction that policies that stimulate liquidity and ameliorate trading costs improve market efficiency.”

In our book “The Incredible Shrinking Alpha,” Andrew Berkin and I presented the evidence demonstrating that the likelihood of active managers to outperform has been persistently declining for decades. We provided explanations for the persistent trend: academics converting what was once alpha into beta (exposure to a common factor); a shrinking pool of victims to exploit (as the percentage of trading done by “dumb” retail money declines); increasing skill of the competition; and an increase in the amount of assets chasing the shrinking pool of alpha. Glosten, Nallareddy and Zou provided a fifth explanation: the growth of ETFs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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