The adverse selection component of exchange traded funds

The aim of our paper is to examine whether Exchange Traded Funds (ETFs) diversify away the private information of informed traders. We apply the spread decomposition models of Glosten and Harris (1998) and Madhavan, Richardson and Roomans (1997) to a sample of ETFs and their control securities. Our results indicate that ETFs have significantly lower adverse selection costs than their control securities. This suggests that private information is diversified away for these securities. Our results therefore offer one explanation for the rapid growth in the ETF market.

Exchange-traded funds and information asymmetry

This thesis focuses on three main questions. The first uses ExchangeTraded Funds (ETFs) to evaluate estimated adverse selection costs obtained spread decomposition models. The second compares the Probability of Informed Trading (PIN) in Exchange-Traded Funds to control securities. The third examines the intra-day ETF trading patterns. These spread decomposition models evaluated are Glosten and Harris (1988); George, Kaul, and Nimalendran (1991); Lin, Sanger, and Booth (1995); Madhavan, Richardson, and Roomans (1997); Huang and Stoll (1997). Using the characteristics of ETFs it is shown that only the Glosten and Harris (1988) and Madhavan, et al (1997) models provide theoretically consistent results. When the PIN measure is employed ETFs are shown to have greater PINs than control securities. The investigation of the intra-day trading patterns shows that return volatility and trading volume have a U-shaped intra-day pattern. A study of trading systems shows that ETFs on the American Stock Exchange (AMEX) have a U-shaped intra-day pattern of bid-ask spreads, while ETFs on NASDAQ do not. Specifically, ETFs on NASDAQ have higher bid-ask spreads at the market opening, then the lowest bid-ask spread in the middle of the day. At the close of the market, the bid-ask spread of ETFs on NASDAQ slightly elevated when compared to mid-day.

Intraday trading patterns in London listed exchange traded funds

In this paper we examine the intraday trading patterns of Exchange Traded Funds (ETFs) listed on the London Stock Exchange. ETFs have been shown to be characterised by much lower bid–ask spread costs and by lower levels of information asymmetry than individual securities. One possible explanation for intraday trading patterns is that concentration of trading arises at the start of the trading day because informed traders have private information that quickly diminishes in value as trading progresses. Since ETFs have lower trading costs and lower levels of information asymmetry we would expect these securities to display less pronounced intraday patterns than individual securities. We fail to find that ETFs are characterised by concentrated trading bouts during the day and therefore find support for the argument that information asymmetry is the cause of intraday volume patterns in stock markets. We find that ETF bid–ask spreads and volatility are elevated at the open but not at the close. This lends support to the “accumulation of information” explanation that sees high spreads and volatility at the open as a consequence of information accumulating during a market closure and impacting on the market when it next opens.

Evaluating spread models with a basket security

In this article we evaluate the most widely used spread decomposition models using Exchange Traded Funds (ETFs). These funds are an example of a basket security and allow the diversification of private information causing these securities to have lower adverse selection costs than individual securities. We use this feature as a criterion for evaluating spread decomposition models. Comparisons of adverse selection costs for ETF's and control securities obtained from spread decomposition models show that only the Glosten-Harris (1988) and the Madhavan-Richardson-Roomans (1997) models provide estimates of the spread that are consistent with the diversification of private information in a basket security. Our results are robust even after controlling for the stock exchange. © 2011 Copyright Taylor and Francis Group, LLC.