Swedroe: ETFs A Double Edged Sword

December 28, 2016

The authors also note that a parallel trend in the marketplace over the last few decades is an increase in concentration in the asset management space, with a likely explanation being the economies of scale that make consolidation attractive. They observe that some have argued that ETFs are poor at corporate governance. Consequently, private firms are reluctant to list on stock exchanges because passive investors—and primarily ETFs—slow price discovery and may eventually jam value signals to managers.

However, Ben-David, Franzoni and Moussawi present evidence that contradicts such claims. For example, they discuss a study that found when a stock moves from being at the bottom of the Russell 1000 Index to the top of the Russell 2000 Index, a sharp increase in institutional ownership occurs, primarily among passive indexers. That study found that, as ownership by index funds increases, firms become more transparent in their reporting.

Another study the authors discuss also found positive effects of increased ownership by passive investors on corporate governance, including the removal of poison pills, restrictions on shareholders’ ability to call special meetings, fewer dual-class share structures and more independent directors.

One interesting finding that Ben-David, Franzoni and Moussawi address comes from a study showing that retail traders who invest in ETFs perform worse than retail traders who stick with traditional mutual funds. The authors of that study argued that the ease of trading with ETFs leads retail investors to attempt to time the market. Because retail investors have been shown to be bad traders in general, this behavior results in poor performance.

Information Efficiency And Liquidity

The third part of Ben-David, Franzoni and Moussawi’s paper focuses on how ETFs affect information efficiency in financial markets. The authors note that while not all researchers agree, studies have found stocks incorporate information more quickly once they are in ETF portfolios.

Studies have made the case that some of the aforementioned increase in co-movement in the prices of stocks within an index (which has been documented by other financial researchers) can be explained through better incorporation of systematic information into stock prices. In an opposite direction, ETFs may decrease the liquidity of their underlying securities. Specifically, because ETFs provide an inexpensive way to trade illiquid assets, they can crowd out traders from the underlying assets and detract liquidity.

For example, one study found that the introduction of corporate bond ETFs leads to a decrease in the liquidity of the underlying bonds, suggesting a crowding-out effect. Another interesting finding is that studies have concluded that equity volatility increases substantially following an increase in ETF ownership.

 

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