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.
As a result, traders will have less incentive to bid for the stocks in anticipation of future earnings increases, so the individual stocks become less responsive to new company updates.
The study also revealed that the number of analysts covering a stock has declined as ETF ownership of a company stock increases, which has left out insightful opinions or data points that would have made it “more likely to converge on the truth if you have more people searching for it,” Suhas Sridharan, one of the paper’s authors and a professor of accounting at UCLA, told the WSJ.
Lastly, with less company-specific analysis floating around, stock price movements will be largely affected by industrywide or general market moves, which helps explain the greater correlation between equities. The study discovered that when ETF ownership of a company stock rises, price moves are more in line with broad market or industry groups. [Increased Index ETF Usage Promotes Stock Correlation Across the Board]
For more information on the ETF industry, visit our current affairs category.
Max Chen contributed to this article.