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

Jeff Madura and Thanh Ngo

Applied Financial Economics, 2008, vol. 18, issue 12, 995-1007

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.

Date: 2008
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DOI: 10.1080/09603100701335424

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