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ETF Trading and Informational Efficiency of Underlying Securities

This paper investigates the effect of exchange-traded funds’ (ETF) trading activity on the informational efficiency of their underlying securities. We find that ETF trading increases informational efficiency for stocks with weak information environments and for stocks with imperfectly competitive equity markets. The increase in informational efficiency results from the timely incorporation of systematic earnings information. In contrast, we find no such effect for stocks with stronger information environments and stocks with perfectly competitive equity markets. ETF trading increases return co-movement, and this increase is partly attributable to the timely incorporation of systematic earnings information. Using S&P 500 index additions and deletions as an additional setting and Russell 1000/2000 index reconstitution as an identification, we corroborate our main findings.