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FSA in an ETF world

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  • Russell J. Lundholm

    (University of British Columbia)

Abstract

This paper models the value of conducting financial statement analysis (FSA) in the presence of an electronically traded fund (ETF) that gives exposure to the firm’s systematic value. FSA is characterized as a costly process that yields a private signal about the idiosyncratic portion of a firm’s future payoffs. The value of this signal depends on how efficiently price transmits information to uninformed traders. A popular argument is that ETFs are attracting noise traders away from the underlying firm, making prices more informative and private information less valuable. While I find that prices are more informative after the introduction of an ETF, I show that this isn’t because of a change in the amount or location of noise trading. Holding noise trading constant, ETFs allow informed investors to hedge out exposure to the portion of firm value that they are uninformed about, which causes them to place larger bets on their private information. This is what causes firm prices to be more informative. The introduction of an ETF into an economy thus presents two competing forces on the value of conducting FSA. On the one hand, prices are more informative after the arrival of an ETF, making private information less valuable, but on the other, informed traders can use the ETF to hedge, making private information more valuable. I characterize how these forces trade off as a function of the exogenous noise in the economy. These results are unavailable in previous theoretical papers about ETFs, because they modeled investors as being risk neutral, thus eliminating their desire to hedge out uncertainty.

Suggested Citation

  • Russell J. Lundholm, 2021. "FSA in an ETF world," Review of Accounting Studies, Springer, vol. 26(4), pages 1428-1455, December.
  • Handle: RePEc:spr:reaccs:v:26:y:2021:i:4:d:10.1007_s11142-020-09571-8
    DOI: 10.1007/s11142-020-09571-8
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    References listed on IDEAS

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    More about this item

    Keywords

    Financial statement analysis; Electronically traded funds; Value of information;
    All these keywords.

    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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