• Lawrence Glosten, Suresh Nallareddy, and Yuan Zou
  • Management Science, forthcoming
  • A version of this paper can be found here
  • Want to read our summaries of academic finance papers? Check out our Academic Research Insight category

What are the Research Questions

The Securities and Exchange Commission (SEC) has called for more research and discussion on the impacts of ETFs. In a previous post, we covered why ETF’s have not screwed up correlations, liquidity, and alpha opportunities. However, here is another post from Wes that outlines arguments that ETFs may screw up stock market efficiency. In short, how ETFs affect stock market efficiency is an ongoing debate.

In this paper, the authors investigate ETF’s further with the following research questions:

  1. Does ETF activity(1) increase short-run informational efficiency?
  2. Is the increase in informational efficiency attributable to systematic or idiosyncratic information?
  3. What is the relation between ETF activity and post-earnings-announcement drift (PEAD)?
  4. Is there a link between ETF activity and active share lending?

What are the Academic Insights?

Using a large cross-section of ETF holdings data from January 2004 to December 2013, the authors find the following:

1. YES- ETF activity increases the informational efficiency by improving the link between short-run fundamentals and stock prices. Specifically, firms with more ETF activity reflect incrementally more earnings information in their current stock returns. Specifically, the authors find significant and improved short-run informational efficiency among small firms (firms with market capitalization below the NYSE 50th percentile) and stocks with low analyst following (firms with analyst following below the 75th percentile). In contrast, they are unable to document such improvement for big firms and stocks with high analyst following.

2. The authors find evidence consistent with the conjecture that ETF activity results in prices that reflect systematic information in a timely manner rather than idiosyncratic earnings information, resulting in increased short-run informational efficiency. In particular, they decompose earnings into its systematic and firm-specific components finding that the commonality component of earnings explains the increase in short-run informational efficiency but not the idiosyncratic firm-level earnings.

3. The authors find that ETF activity is associated with lower PEAD strategy returns. Specifically, the difference in five-factor adjusted returns to the PEAD strategy between low and high ETF activity is 0.88%, and it is statistically significant at the 1% level. This evidence suggests that ETF activity incorporates information quickly into stock prices, which results in lower PEAD strategy returns as the ETF activity increases.

4. YES- the authors find that ETF activity is positively related to active share lending, which may reduce shorting costs.

Why does it matter?

This study makes several contributions to the literature. Specifically, it documents whether, how, and when ETF activity increases the short-run informational efficiency of underlying stocks. ETF activity increases the short-run informational efficiency for firms with weak information environments by incorporating systematic accounting information into stock prices in a timely manner. In contrast, there is no such effect for firms with stronger information environments.

Additionally, by documenting the effect of ETF activity on the informational efficiency of the underlying stocks, we provide evidence in support of the long-standing prediction that policies that stimulate liquidity and ameliorate trading costs improve market efficiency.

The Most Important Chart from the Paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.


This paper investigates the effect of exchange-traded funds’ (ETF) activity on the short-run informational efficiency of their underlying securities. We find that ETF activity increases short-run informational efficiency for stocks with weak information environments. 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. ETF activity increases return co-movement, and this increase is partly attributable to the timely incorporation of systematic earnings information. Further, ETF activity is associated with an attenuation of post-earnings-announcement drift and an increase in active share lending.

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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