Active fundsters who are unhappy with the rise of ETFs now have fuel for their griping. New research suggests that ETFs are messing with the efficiency of Mr. Market.

Suhas Sridharan UCLA Anderson School of Management Assistant Professor of Accounting

In "Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective", a research paper highlighted in the Wall Street Journal, professors from the Arison School of Business in Israel, Stanford, and UCLA conclude that ETFs are driving all sorts of bad effects thanks to encouraging some individual and institutional investors to give up directly trading some stocks.

The paper's logic goes like this. Fewer investors directly trading a particular stock means higher bid-ask spreads for that stock, six-percent wider per this new research if more than three percent of shares outstanding are held by ETFs. That cuts into traders' profits, reducing their incentive to trade in that stock. And that makes the price of that stock less responsive to changes and news.

The researchers also observed a drop in the number of analysts covering a stock as ETFs own more of that stock. And that gives investors less to go on when choosing stocks.

They also found, not surprisingly perhaps, that stocks with high ETF ownership tend to move more in sync with their industry and the broader market. And diversification and stock-picking are harder when stocks are more in sync with each other.

So now non-ETF fundsters can accuse heavy ETF users of hurting the markets for the rest of us. 

Edited by: Neil Anderson, Managing Editor


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