The Effect of ETF Trading on Benchmark Securities: Evidence from Adoption of ETF Creation in Israel

Exchange-traded funds (ETF) offer a low-cost way to invest in illiquid, small securities and, through the creation/redemption mechanism feature a tight connection between passive flows and trading in the index equities. Yet the literature starkly disagrees on how ETF trading affects benchmark securities. We use a 2012 reform that introduced the ETF creation mechanism to the Tel Aviv Stock Exchange to estimate the causal effect of ETF trading on benchmark stocks, leveraging the fact that passive ownership increased by 3% of market capitalization more in small than in large equities. A 1 p.p. increase in ETF ownership as a percent of market capitalization increased equity prices of small stocks by 11.7%. Effects persist for up to two years, significantly shifting capital towards smaller firms and reducing market concentration. Moreover, benchmark liquidity significantly increases and more so for small stocks. We benchmark our results to the literature by estimating the slope of the demand curve for stocks. We find it is more inelastic than has been estimated using U.S. data. We interpret this and the strength of small-stock effects as evidence that the effect of ETF trading is dependent on the severity of limits to arbitrage.