Exchange-traded funds (ETFs) have become increasingly popular with investors. They allow you to invest in a basket of stocks and help you take advantage of trends in a sector rather than betting it all on one company. But do ETFs distort stock returns and affect stock prices?
ETFs can distort and impact stock prices due to trading noise caused by uninformed investors buying and selling. The impact caused by the noise isn’t a permanent change to a stock’s value and is thought to be a temporary distraction. However, ETFs can affect stock returns and prices.
To understand how ETFs can distort stock returns and affect stock prices, we need to know what they are, how trading works, and why investors buy them. In this article, I will explain all of these things and how their use can impact financial markets, particularly stock prices and returns.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is an ETF?
Exchange-traded funds (ETFs) are a type of investment similar to mutual funds but trade on a stock exchange the same way as stocks. Today, ETFs regularly have billions of dollars in assets under management, and their popularity is steadily growing.
ETFs Are Similar to Mutual Funds
A mutual fund is a financial investment mechanism with a portfolio of securities. Mutual funds typically hold stocks and bonds.
Trading within a mutual fund’s portfolio can only be conducted after the markets close at the end of the trading day, which means the prices don’t fluctuate throughout the day.
Like a mutual fund, an ETF holds a portfolio of securities, which could be stocks, bonds, commodities, or even precious metals. Investors may buy or sell an ETF anytime while the markets are open at whatever the price is at the time.
A professional, usually a team, actively manages a mutual fund and decides how to allocate monies collected from investors or market gains. This manager is responsible for the fund’s performance.
The ETF’s sponsor designs the portfolio to match the performance of the index it’s tracking. The creator of the ETF uses the same weights as the tracked index. Therefore, the portfolio is considered to be passively managed.
This methodology allows the ETF fees to be much lower than the actively managed mutual fund, making ETFs more cost-effective.
Advantages of ETFs
Because ETFs are passively managed, you don’t have a team of money managers or other administrative costs to pay.
Lower administration and operating costs result in a lower expense ratio and higher returns. It also means there’s lower investment risk.
In addition, an ETFs portfolio contains a highly diversified collection of securities. One ETF may include a large group and variety of stocks, which spreads the risk out across those individual investments. ETFs are known for their high liquidity, which also makes them a less risky investment.
ETFs are traded throughout the day while markets are open, like stocks. Intraday trading offers more flexibility and transparency to investors as the price of shares varies during the trading day.
The transparency benefits investors because they know the cost of the trade at the time the transaction executes.
Conversely, investors only see the mutual fund trade cost after the markets close, and net asset value (NAV) is determined.
Another essential advantage of ETFs is the lower capital gains taxes. The way mutual funds are structured causes more capital gains taxes because investors incur them throughout the investment period. ETFs, on the other hand, only incur capital gains tax when selling them.
Disadvantages of ETFs
When trading stocks, in many cases, there’s a brokerage fee assessed. This fee is the cost that the brokerage firm charges for placing the transaction. As stated previously, ETFs trade like stocks, so they’re also subject to a fee.
Although, some brokerage firms offer transactions with zero commission on some ETFs.
Lower capital gains tax is a benefit with ETFs, but the tax advantage with dividends isn’t. The disadvantage is due to the length of the holding period required to classify the compensation as qualified.
If an investor has an ETF less than 60 days before the dividend payout date, it’s considered an unqualified dividend and taxed at their income tax rate. If held longer than 60 days, the IRS calculates the dividend tax with a qualified rate between 5% and 15%.
There’s more complexity with ETFs than mutual funds, which may mean the investor doesn’t fully understand the difference between the products in its portfolio.
In addition, the ETFs’ settlement period may confuse investors. Money exchanges after processing and verification of the trade are complete; this is the settlement date.
A mutual fund’s settlement date is one day after placing the transaction. ETFs have a two-day settlement period.
Why Were ETFs Created?
ETFs were introduced in the 1990s to provide individual investors access to index funds. Index funds were first developed in 1973 by Wells Fargo and American National Bank and offered to their institutional customers.
When John Bogle developed the First Index Investment Trust in 1975, it was available to the public. Some didn’t believe it would be successful. However, it started with assets of $11 million and grew to $441 billion by 2019.
The fund’s success paved the way for more of this type of investment to be made available to the public. In May 2020, more than 7,100 ETFs were trading worldwide, with more than 2,200 in the United States.
How Do ETFs Affect Stock Prices and Returns?
Rising ETF stock ownership can affect stock prices and returns according to research from the National Bureau of Economic Research. ETF held stocks undergo considerably higher levels of daily volatility and turnover compared to stocks not withheld in high volume ETFs.
For instance, a one-standard-deviation increment in ETF ownership could result in a 16% increment in daily stock turnover and volatility.
Generally, uninformed investors prefer trading ETFs over individual stocks so as to avoid trading against more informed investors. Due to their migration to ETFs, the markets for individual stocks become less liquid as ETFs become more widely available.
As more investors increasingly move from stocks to ETFs, the trading costs associated with the underlying baskets of securities continue to increase.
The latter forms the primary driving channel of stock price volatility.
Furthermore, with the increased divergence between ETF prices and their underlying securities (thus a higher opportunity for potential returns from arbitrage trading activity between them), the turnover and volatility of ETF stocks soar correspondingly higher.
Again, with more growth in ETF ownership, stock price movements tend to align much more with the market or industry and less with firm-specific information. Thus, the flows into and out of ETFs lead to increased stock volatility as ETFs add noise to stock prices.
The research concludes that the impact of ETF arbitrage on stock prices seems to end after a couple of days, a situation that’s in line with ETFs adding noise to equity prices.
Informed investors understand the fundamentals of trading. As a result, when they buy or sell securities, they actively track them and time the transactions to the market.
Besides, if they trade a stock within an ETF, they understand pretty well how it could impact the market. Uninformed investors, on the other hand, are not that well informed about financial securities or how to evaluate their fundamentals.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
The number of ETFs and other similar passive investments has shown rapid growth since financial institutions introduced them.
As this growth continues, more informed and uninformed investors will be buying and selling them. The increase in trading will cause a continuation and a possible rise in stock volatility.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
Recent Posts
Exploring Social Trading: Community, Profit, and Collaboration
Have you ever wondered about the potential of social trading? Well, that curiosity led me on a fascinating journey of surveying over 1500 traders. The aim? To understand if being part of a trading...
Ah, wine investment! A tantalizing topic that piques the curiosity of many. A complex, yet alluring world where passions and profits intertwine. But, is it a good idea? In this article, we'll uncork...