ETFs and information acquisition

Abstract

I examine how exchange-traded funds (ETFs) affect incentives to produce information about individual securities. Due to their low trading costs, ETFs can be used to trade on information about less liquid and more constrained stocks that have large weights in the ETF. Using introductions of options on sector ETFs as events that reduce costs of trading on private information, I find that small stocks with large ETF-weight experience an increase in price informativeness compared to similar low ETF-weight stocks. In contrast, I do not find such an effect for large stocks. I conclude that by providing a cheaper way to trade on stock-specific information, ETFs facilitate information acquisition about large ETF-weight stocks, leading to more informative prices.