The effect of ETFs on stock liquidity

This paper investigates the effect of the introduction of exchange-traded funds (ETFs) on the liquidity of individual stocks. Prior analytical studies suggest that uninformed investors strictly prefer trading ETFs to trading individual stocks in order to avoid trading against informed investors. As a result of uninformed investors’ migration, the markets for individual stocks are predicted to become illiquid as ETFs become widely available. Using ETF trading and holdings data between 2002 and 2008, I test the hypothesis that the higher the percentage of a firm’s shares held by ETFs, the higher the adverse selection cost to trade the firm’s stock. I find that the availability of ETFs as an alternative trading option is positively associated with the adverse selection component of bid-ask spreads of stocks in ETFs. The positive association is shown to be stronger with ETFs holding more diversified portfolios of stocks, as uninformed investors’ incentives to switch are stronger for more diversified ETFs. The increase in the adverse selection costs of individual stocks is transferred to the ETF-level adverse selection costs, and diversified ETFs are especially shown to suffer from illiquidity of their underlying stocks. This dynamics between stock-level and ETF-level adverse selection casts a doubt whether uninformed investors can avoid the adverse selection cost by trading ETFs as effectively as expected