(Bloomberg) -- ETFs are making stock markets dumber — and more expensive.
That's the finding of researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel. They've uncovered evidence that higher ownership of individual stocks by ETFs widens the bid-ask spreads in those shares, making them more expensive to trade and therefore less attractive.
This phenomenon eventually turns stocks into drones that move in lockstep with their industry. It makes life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals.
The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds.
"ETFs are clearly an important development in financial markets, which have brought many well-documented benefits to investors," researchers Doron Israeli, Charles Lee and Suhas Sridharan wrote in a paper last month. "Our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities."
A single percentage point increase in ETF ownership has demonstrable effects on an individual stock, the researchers found. Over the ensuing year, correlation to the share's industry group and the broader market ticks up 9%, while the relationship between its price and future earnings falls 14%. Meanwhile, bid-ask spreads rise 1.6% and absolute returns grow 2%.
The cause? Unsophisticated investors and the ways they buy securities. Before index funds, traders who thought they knew something others didn't could turn a profit in transactions with less informed buyers of individual stocks. That disadvantaged cohort now buys ETFs, locking up securities that traders once could pick off when price discrepancies arose.
The detrimental effects to the market snowball from there. Fewer trades occur, so liquidity in single stocks deteriorates, raising transaction costs. That only further discourages professional traders, so the price discrepancies remain without the informational arbitrage to close the gaps.
Making matters worse, the reduced interest in individual equities also results in less analyst coverage, the researchers argue.
However, not everyone's sold on the findings.
State Street, the third-largest issuer of ETFs, hasn't observed any measurable difference in bid-ask spreads as a result of their usage, Dave Lavalle, head of SPDR ETF capital markets, said on a panel last month. Correlation between S&P 500 members also hovers near a record low, siting 47% below the six-year average.
What's more, the funds, while growing, still represent a fraction of the overall U.S. market. More than $1.8 trillion of the U.S. equity market is held by the funds, a $460 billion increase over the past three years, aided by record inflows in 2017. However, Goldman Sachs Group pegs passive investors at around 14% of the S&P 500, up from 9% in 2013.
The idea of tighter correlations and a dumber market as consequences of index fund usage is well trodden territory in doomsday ETF literature. A Virginia Tech paper in 2014 found that fewer signals about corporate performance seeped into prices over time because of passive investing. Instead, the investors arrive all at once when earnings results are disclosed.
Goldman Sachs last month found that institutional stock pickers held a record amount of ETFs. That coincided with sector correlation falling below individual stock correlation for the first time since at least 2011, meaning industry bets mattered more than single-stock bets as passive vehicles chopped up the market into sectors.
Still, the researchers on the most recent report note an important caveat to their findings. Though higher ETF ownership coincides with higher trading costs, "this association alone does not imply causality," they wrote. Index funds are just the most likely culprit, they reason.
"ETF's are a great innovation, but an over-population of any innovation could cause unintended consequences if left unmonitored," said Troy Draizen, global head of electronic trading at Convergex Executive Solutions. "We have seen this in many market cycles, from dot-com to the credit crisis."