Lost in the Rising Tide : ETF Flows and Valuation

The last decade has witnessed a dramatic growth in passive investing via exchange-traded funds (ETFs). To the extent that the demand for stocks via ETF flows is not related to firm-specific fundamental values, large ETF flows may push the price of the underlying stocks away from their fundamentals-based value. In this study I provide evidence consistent with this conjecture. In particular, I first document a positive association between ETF flows and the price-tofundamentals relation of underlying stocks. Then, by using BlackRock’s expansion into the ETF business as an exogenous shock, I provide evidence that the association is likely to be causal rather than reflect some form of endogeneity (i.e., ETFs selecting certain stocks). Also, I find that highflow firms subsequently underperform low-flow firms in operating and stock performance, consistent with the misvaluation being caused by non-fundamental demand shocks. Crosssectional tests suggest that the ETF-related misvaluation is stronger for stocks with: a less competitive equity market (i.e., with prices more sensitive to demand shocks), lower ownership by active investors, and more costly arbitrage constraints. Finally, I find that high-flow firms exhibit behavior typically associated with perceived overvaluation (e.g., more secondary equity offerings).  For their guidance and support, I especially thank the members of my dissertation committee: Stephen Penman (chair), Fabrizio Ferri, Lawrence Glosten, Jonathan Glover, and Shiva Rajgopal. I thank Sudipta Basu, Thomas Bourveau, Robert Bushman, Matthias Breuer, Wei Cai, Kent Daniel, Richard Frankel, Pingyang Gao, Trevor Harris, Rachel Hayes, Alon Kalay, Jinhwan Kim, David Kwon, Alvis Lo, Doron Nissim, Ethan Rouen, Robert Stoumbos, Hao Xue, Wenhao Yang, Frank Yu, Ronghuo Zheng, Christina Zhu, workshop participants at Columbia, the CMU Emerging Scholar Session, and the SEC Doctoral Symposium for helpful comments. I also thank Bruiser Liu from PhaseCapital, Alex Schiller from the SEC, and multiple investment professionals for providing institutional insights. This project has also benefited from discussions with my fellow students Serene Huang, Yiran Kang, Venkat Peddireddy, and Kunjue Wang. I thank Martijn Cremers for making active shares data available. I am also thankful for the financial support from the Columbia Accounting Alumni Award, the W. Edwards Deming Center, and the Duncan Merriwether Doctoral Fellowship. All errors are my own.