We investigate the impact of active managers on the information efficiency of the underlying assets in passive ETF portfolios. Specifically, we explore how the increasing popularity of ETFs prompts active mutual fund managers to execute informed trades that generate alpha. Using trade-level data, we test whether trades by skilled active managers more accurately predict future abnormal stock returns as ETF ownership in these stocks rises. By leveraging the annual reclassification of stocks from the Russell 1000 to the Russell 2000 as an exogenous variation, we find that high-performing mutual funds can mitigate the pricing inefficiency typically associated with ETFs.

This paper presents a novel mechanism through which the lack of consensus on corporate bond valuation affects corporate bond ETF creation. Although multiple ETF issuers can accept the same bond during the “in-kind” creation process, they often value it differently. Valuation dispersion is driven by external pricing sources but can also reflect ETFs’ efforts to minimize tracking errors. In their role as Authorized Participants (APs), dealers can benefit by delivering a bond to the ETF that values it higher while maintaining a lower overall valuation tendency. This strategic behavior benefits APs but dilutes the holdings of existing ETF investors to an extent similar to that of the funds’ expense ratio.

We examine how investors respond to reduced stock liquidity by turning to exchange- traded funds (ETFs). Using the SEC’s Tick Size Pilot Program as a natural ex- periment, we find that ETF trading volume increases by 44% for funds with greater exposure to affected stocks. Despite holding less liquid equities, these ETFs maintain stable trading costs and expand supply—shares outstanding rise by 20%. Market cap- italization grows by 23% without an increase in volatility. These results show that ETFs act as liquidity substitutes during periods of market stress, offering investors a lower-cost, accessible way to maintain exposure when stock trading becomes costly.