Exchange-traded funds are making stock markets dumber—and more expensive.
That’s the finding of researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel.
They’ve uncovered evidence that higher ownership of individual stocks by ETFs widens the bid-ask spreads in those shares, making them more expensive to trade and therefore less attractive.
This phenomenon eventually turns stocks into drones that move in lockstep with their industry. It makes life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals.
The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds.
“ETFs are clearly an important development in financial markets, which have brought many well-documented benefits to investors,” researchers Doron Israeli, Charles Lee and Suhas Sridharan wrote in a paper last month. “Our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities.”
A single percentage point increase in ETF ownership has demonstrable effects on an individual stock, the researchers found. Over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9 percent, while the relationship between its price and future earnings falls 14 percent. Meanwhile, bid-ask spreads rise 1.6 percent and absolute returns grow 2 percent.
The cause? Unsophisticated investors and the ways they buy securities. Before index funds, traders who thought they knew something others didn’t could turn a profit in transactions with less informed buyers of individual stocks. That disadvantaged cohort now buys ETFs, locking up securities that traders once could pick off when price discrepancies arose.
Less Trading
The detrimental effects to the market snowball from there. Fewer trades occur, so liquidity in single stocks deteriorates, raising transaction costs. That only further discourages professional traders, so the price discrepancies remain without the informational arbitrage to close the gaps.