Basket Securities, Price Formation, and Informational Efficiency

This paper investigates the role of basket securities in the efficient price formation process of individual component securities. The study focuses on one type of basket security, exchange traded funds (ETFs), which includes some of the most actively traded securities in the U.S. equity market. A multi-asset variance decomposition methodology is developed to measure the information contributions of the return and trade innovations of ETFs. The results show that a substantial amount of the information incorporated into the efficient price of a component stock originates in the ETF market. More interestingly, ETF trades are found to have permanent impacts on component stock prices. An analysis of ETF introductions reveals that both informational efficiency and market liquidity of the component stocks improve after the ETF starts trading. The findings suggest that seemingly redundant securities can have important informational functions. Basket Securities, Price Formation, and Informational Efficiency Why do markets exist and thrive for some securities but not others? Most theoretical explanations emphasize the spanning role of securities. However, with asymmetrically informed market participants, the role of aggregating and transmitting private information could be equally important. The notion of the informational role of security markets was first proposed in a noisy rational expectations equilibrium context by Sandy Grossman in his doctoral dissertation in 1975. Rahi (1995) and Duffie and Rahi (1995) provide a theoretical framework where the risk-allocation and information-transmission functions are distinct. In their parametric framework, a more efficient outcome can be achieved by designing the payoff structure of financial securities to increase their effectiveness in the aggregation and transmission of private signals without changing their hedging effectiveness. This paper investigates the informational function of security markets by focusing on securities that seem redundant from a hedging perspective. The question of interest is how the trading of these securities affects the process of price formation, hence also the informational efficiency and market quality of the underlying securities. These issues are of particular consequence since the informational quality of individual security markets may have important implications for the efficiency of a firm’s investment decisions. This paper uses a type of basket security — exchange traded funds (ETFs) — to empirically examine the contributions of redundant securities to price formation and efficiency at the individual stock level. See, for example, Duffie and Jackson (1989). Allen and Gale (1994) provide an extensive survey. The paper was published in 1977. See reference under Grossman (1977). The market price of a firm’s stock guides its managers’ decisions by transferring information about investment opportunities and about managers’ past decisions. See Dow and Gorton (1997) and Subrahmanyam and Titman (2001). Prior studies treated ETFs as index products and mainly focused on index-level phenomena. Ackert and Tian (2000) and Engle and Sarkar (2002) examine the dynamics of price deviations of ETFs from the underlying indexes. Elton et al.(2002) compare the long-run investment performance of SPDR with the performance of the index and other indexed products. Poterba and Shoven (2002) measure the tax efficiency of ETFs in comparison with traditional index mutual funds. Boehmer and Boehmer (2003) and Erenburg and Tse (2002) find reduced transaction costs and improved market quality for ETFs after they started trading on the NYSE. Hasbrouck (2003) looks at ETFs’ contribution to the process of price formation on the index level.