Impact of ETF inception on the valuation and trading of component stocks

Abstract

While exchange-traded funds (ETFs) are being created at a rapid rate, there is very limited research on how they affect the component stocks that they contain. We find that in response to the inception of ETFs, there are positive and significant valuation effects on the dominant component stocks (defined as the 10 largest stocks in each ETF). The variation in the valuation effects is associated with stock-specific characteristics, such as relatively low liquidity and the size of the ETF in which the component stock is contained. The characteristics of the component stocks that experience more favourable valuation effects at the inception of ETFs also lead to a more pronounced increase in their trading volume following their ETF's inception. The increase in trading volume is especially pronounced for those component stocks that are relatively small, have relatively low levels of liquidity, and are contained within relatively large ETFs.

Acknowledgement

We thank Nivine Richie for her valuable comments.

Notes

¹The difference between the multivariate model applied here vs. the model used to explain valuation effects is that this model does not include stock volatility. We hypothesized earlier that more volatile stocks could benefit more from the inception of the ETF. However, we do not have a hypothesis for how a component stock's volatility before the ETF inception would affect the change in its trading volume in response to ETF inception. Nevertheless, we included a volatility variable in multivariate models applied to changes in trading volume. The variable was not significant when applied to the entire sample or to any subsample categorized by type of ETF. In addition, the significance status of all other variables in the model is not significant.