Price discovery and liquidity in basket securities

Basket securities enable investors to purchase a broad portfolio of securities in a single transaction. We examine the link between HOLDRS, a basket security comprising stocks from an industry or sector, and the underlying stocks. We find that the price of the portfolio of underlying securities leads and is more informative than the basket price. Our results are contrary to the findings of empirical studies that use futures, which are basket securities with features less like those of the underlying equities. Our findings suggest uninformed investors can minimize adverse selection costs by trading basket securities rather than the underlying stocks.