The Interrelationship Between ETFs And Underlying Stocks

ETFs, combining the advantages of open-ended and close-ended funds, with the c haracteris-tic of indexing investment, provide a convenient asset allocation method for investors to conduct portfolio investment. Among the microstructure studies of the liquidity in securities market, the effect of ETFs on underlying stocks is obscure. On one hand, while offering great diversity of indexing investment to investors, ETFs intrigue the uninformed investors to change from the stock market to baskets of stocks market to avoid trading with the informed investors on individual stocks. Under this logic, along with the migration of uninformed investors, the individual stocks suffer from illiquid-ity with the popularity of ETFs. On the other hand, the arbitrage opportunities of ET-Fs will promote the liquidity of underlying stocks. Since arbitraging ETFs between the first class market and the second is high correlated with their underlying stocks, the two opposite effects cast a shadow on the interrelationship between ETFs and un-derlying stocks, which demands more samples and methods to explore.When asymmetric information existed among traders in stock market, there are costs of adverse selection trading in the market, and the bid-ask spread reflects the degree of asymmetric information. This dissertation is based on the market micro-structure theory, focusing on the adverse selection cost in the bid-ask spread and us-ing it as the index of liquidity, to research the liquidity influence caused by informa-tional asymmetry from the model in Kyle(1985). I apply the MRR model to decom-pose the bid-ask spread to get the adverse selection cost, lambda, and test the hypoth-esis of adverse selection. The sample includes42active trading underlying stocks which haven’t been changed during December,2009to December,2013. There are totally46,430,392intra-day trading and price data of these underlying stocks. Besides, I also collect303,444,625intra-day data of all ETFs in China from Feburary,2013to Feburary,2014to research the adverse selection cost of ETFs. Thus, I conduct two panel analysis and find out that:1. The higher percent holding by ETFs, the higher adverse selection cost of the individual stocks.2. The more diversified ETFs have the smaller adverse selection cost.