Exchange traded funds are becoming the go-to investment vehicle to gain market exposure, which has led to increased correlation in the equities market, higher trading costs in individual securities and diminished demand for stock analysis.
According to an academic paper, titled “Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective,” the popularity of ETFs has led to increased trading costs for some stocks, less analyst coverage on individual companies and reduced the responsiveness of some stock prices to company information.
As ETFs attract more individual and institutional investors, individual stocks are losing their appeal, which has left fewer opportunities for professional traders to profit from trading the stocks, reports Simon Constable for the Wall Street Journal.
The report argues that as ETF providers hold an increasing portion of underlying equities in companies that they use for their index-based ETFs, the ETF managers diminish the number of shares available to other traders, reports Chris Flood for the Financial Times.
Consequently, the resulting distortions in the share prices of those component companies held by index funds could be a factor in explaining why active stockpickers are seeing costs rise and failing to deliver alpha.
For instance, the bid-ask spread is 6% wider on average when an ETF owns a large chunk of a company’s share, or over 3% of the shares outstanding, compared to the spread when a stock has lower or no ETF ownership.