Previous studies have highlighted negative effects of the growth of passive investment, especially index tracking ETFs, in recent years.
In addition to increasing market volatility ETFs have been shown to lead to lower price efficiency, higher return synchronicity and less analyst coverage of securities in underlying baskets.
Researchers from the University of Utah wanted to know, in addition, if the rise of ETF investing was related to the increased/decreased liquidity in big/small capitalization stocks that’s been a feature of markets in recent years?
Previous academic models assumed ETF operators replicate an index and there shouldn’t be much of an effect (index stocks would get more expensive but that had been happening for different reasons anyway); but this study shines a light onto the reality of ETF operation. The most important of which is the operator-necessity to reduce the cost of implementation.
For this reason, cost, ETF managers don’t replicate 1:1 the underlying basket of stocks an ETF represents. They, in fact, concentrate their replication work into the most liquid i.e. cheapest to operate in stocks in their basket; and those are nearly always going to be the biggest.
Along the way the researchers rule out both the effects of market fragmentation and the increase of algorithmic trading to explain the big/small getting more/less liquid phenomenon.
This is important work because, as the researchers note “..as long as ETF trading activity continues to increase, the liquidity gap is predicted to widen even further.”; and what do we think the chances of ETF trading activity decreasing anytime soon are? Quite.
Therefore, if the paper is correct (it almost certainly is) small-cap fans waiting for valuation anomalies to correct are, most likely, wasting their time.
You can access the paper in full via the following link ETF Trading and the Bifurcation of Liquidity.
Happy Sunday.