An analysis of information asymmetry in exchange-traded funds

This study relies on information asymmetry theory to investigate the phenomenal rise in the popularity of exchange-traded funds (ETFs) among investors. ETFs are traded like shares of common stocks, but as passively managed mutual funds their share prices simply reflect concurrent changes in the values of specific stock market indexes the ETFs track (e.g., the S&P 500). The immense popularity of ETFs is puzzling because investors have an alternative strategy that would yield the same investment returns a priori: duplicating the holdings of an ETF by buying and selling proportionate shares of the individual stocks that constitute the market index tracked by the ETF.; Theoretical models elicit testable hypotheses on the information asymmetry relating to investors' revealed preference involving the three most popular ETFs over their counterpart market indexes---SPDRs for the S&P 500 index, DIAMONDS for the Dow Jones Industrial 30 Average, and QQQ for the Nasdaq 100 index. Central to the inquiry is the proposition that the high trading volumes associated with ETFs are primarily attributable to liquidity traders, whose losses from their adverse trades with informed traders are lower when they trade in ETFs than when they trade in the underlying individual securities. The results indicate that the information asymmetry between liquidity traders and informed traders is indeed mitigated in the ETF markets. These markets provide greater liquidity and lower trade informativeness, both of which reduce adverse selection costs for ETF traders over trading the underlying individual securities in the open markets. This study also finds that the SPDRs market has indeed attracted a higher percentage of trading volume from liquidity traders than markets of the underlying individual securities. To further investigate the extremely low trade informativeness associated with SPDRs, the study compares that with basis informativeness in the SPDRs market. The basis is found to convey more private information than trades for the intra-day price revisions in the SPDRs. The empirical results document the essential role of futures trading in designing an active ETF market.