Foxes in the hen-house : single stock traders hiding in ETF order flow

Abstract

Conventional wisdom suggests that exchange traded funds (ETFs) protect uninformed investors from informed traders by diversifying holdings across a basket of securities. Contrary to this belief, I develop a theoretical model where investors with stock-specific information do trade in ETFs whenever the stock's weighting in the ETF is high or whenever the information asymmetry is large. As a result, ETF trades can allow price discovery about specific underlying stocks. High-frequency evidence from Sector SPDR ETFs supports the predictions of my model. I conclude that ETFs, especially narrowly constructed ETFs, are far from immune to single-stock informed trading.