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The Vanishing Bid-Ask Spread and Market Efficiency

Posted in Big Ideas

How has the dramatic increase in trading over the past decade materially affected the stock market environment? In their October 2010 paper entitled “Recent Trends in Trading Activity and Market Quality”, Tarun Chordia, Richard Roll and Avanidhar Subrahmanyam examine trends in trading activity and the impacts of these trends on market efficiency. Using trade and quote data for a broad sample of NYSE stocks over the period 1993 through 2008, they find that:

  • Over the sample period, turnover has increased substantially for both S&P 500  stocks and smaller non-S&P 500 stocks, suggesting that indexation is not responsible for the increase. A dramatic increase in trading frequency more than offsets a decline in trade size (from a typical $80,000 in the mid-1990s to only $7,000 in 2008).
  • Decreasing trading friction and improving trading technology drive the increase in trading.
  • Turnover increases the most for stocks with the highest levels of institutional holdings, such that the market apparently absorbs private information of institutional investors at a faster pace.
  • Over the sample period, intraday volatility decreases and prices more closely follow a random walk both in aggregate and for individual stocks.
  • The sensitivity of turnover to past returns increases, and cross-sectional predictability of returns based on turnover and both short-term and intermediate-term past returns (momentum) significantly decreases, suggesting increased market efficiency derived from intense technical (quantitative) trading.

In summary, evidence indicates that declining trading friction and improving trading technology have stimulated higher turnover, faster incorporation of private information and greater market efficiency over the past 15 years.

Investors should therefore consider:

  • Whether anomalous levels of outperformance inferred from old data can persist in a low-friction market environment.
  • Sacrificing sample size for relevance of current market data in making new inferences.
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