Lawrence Glosten, Suresh Nallareddy & Yuan Zou, ETF Trading and Informational Efficiency of Underlying Securities

Using a large cross-section of ETF holdings data from January 2004 to December 2013, we document that an increase in ETF trading is accompanied by an increase in price informational efficiency of the underlying stocks, as reflected in the increase in the relation between stock returns and earnings news. The effect of ETF trading on information efficiency should be conditional on the information environment and the degree of capital market competition. Consistent with expectations, when we conduct the information efficiency tests within different segments of the market, we find significant and improved informational efficiency among small firms (firms with market capitalization below the NYSE 50th percentile), stocks with low analyst following (firms with analyst following below the 75th percentile), and stocks with imperfectly competitive equity markets (number of shareholders below the 75th percentile). In contrast, we are unable to document such improvement for big firms, stocks with high analyst following, and for stocks with perfectly competitive equity markets.