Academic journal article Journal of Economics and Finance

The Impact of Security Concentration on Adverse Selection Costs and Liquidity: An Examination of Exchange Traded Funds

Academic journal article Journal of Economics and Finance

The Impact of Security Concentration on Adverse Selection Costs and Liquidity: An Examination of Exchange Traded Funds

Article excerpt

Abstract We examine the determinants of liquidity and adverse selection costs in a sample of basket securities. Using Exchange Traded Funds (ETFs), we find evidence that adverse selection costs are decreasing in the number of equities held in the underlying portfolio, but adverse selection costs do not increase as the concentration among the securities increases. We find no evidence that industry concentration increases basket security adverse selection costs or reduces liquidity. We also document significantly lower levels of adverse selection costs in ETFs versus a matched sample of equities. In addition, ETFs have quoted dollar depth that is 35 times larger than a matched sample of equities, but ETFs also have higher effective and quoted spreads. However, when considering spreads and depth in a single metric, ETFs have significantly higher levels of liquidity.

Keywords Exchange Traded Fund (ETF) . Liquidity . Adverse Selection

JEL Classification G00

(ProQuest: ... denotes formula omitted.)

1 Introduction

In this work we explore the relationship between adverse selection costs, as a percentage of the bid-ask spread, and liquidity for a sample of basket securities, namely Exchange Traded Funds (ETFs), and we compare these relationships to a matched sample of equities. Prior theoretical works predict lower adverse selection costs in basket securities relative to individual equities (Subrahmanyam (1991), Gorton and Pennacchi (1993), and Kumar and Seppi (1994)).

While we present the first test comparing adverse selection costs for ETFs and equities, empirical tests comparing mutual funds and equities have generally borne out these predictions, although the differences in adverse selection component of the spread have typically been smaller than expected. Neal and Wheatley (1998) estimate the adverse selection component of the bid-ask spread for 17 mutual funds and a control sample of 17 common stocks. They find the Glosten and Harris (1988) model estimates averaged 19% for the funds and 34% for the control stocks and that the George et al. (1991) model estimates averaged 52% and 65% for the mutual funds and control stocks, respectively. The small difference between estimates of the adverse selection component of the spread for equities and closed-end mutual funds present a problem for Neal and Wheatley. They state: "Adverse selection arises primarily from factors other than a firm's current liquidation value" (p.123), and they also suggest that the adverse selection spread decomposition models may be mis-specified. We test whether their findings may also be related to common factors in the portfolio of underlying securities, and we find evidence that adverse selection costs decrease as the number of equities held in the underlying ETF increases and does not increase as the concentration (using a Herfindahl index) among the securities increases.

We estimate measures of liquidity and the adverse selection component of the bidask spread and test for determinants of the spread component for exchange traded funds. Based on the prior theoretical work and empirical findings comparing adverse selection components of mutual funds to individual equities we expect to find lower adverse selection costs for ETFs than for matched equities. Following Gorton and Pennacchi (1993), one possible reason for these differences is that informed agents may prefer to trade industry concentrated basket securities to avoid detection by regulatory agents or uninformed traders who might be monitoring their trading activities in the underlying securities.

Finally, we explore the determinants of liquidity and the adverse selection component of the spread, focusing on differences in portfolio construction and concentration. Why do some basket securities rank as the most traded instruments in the U.S. market (e.g., QQQQ) and some are in the lowest quartile of trading volume (e.g., MTK), even though they may be concentrated in the same industry or hold common securities? …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.