The Exchange Traded Funds' Pricing Deviation: Analysis and Forecasts

Article excerpt

Abstract

In this paper, we study the pricing deviations of the three most liquid Exchange Traded Funds from the price of the underlying index. We examine Spider, Diamonds, and Cubes and find that their price deviation is predictable and nonzero. Therefore, the pricing deviation can be considered an additional cost of administering an Exchange Traded Fund. The reason for the predictability of the pricing deviation stems from its stationarity. The reasons for the pricing deviation being nonzero are the specific price discovery processes and dividend accumulation and distribution for this asset class. The pricing deviation can be used as a performance metric of Exchange Traded Funds and might motivate arbitrage strategies.

Keywords Exchange Traded Funds * Pricing Deviation

JEL Classification G10 * G14

1 Introduction

In this paper, we study the pricing deviations of the three most liquid Exchange Traded Funds (ETFs) from the price of the underlying index. We examine Spider (the S&P500 tracking ETF); Diamonds (the Dow Jones Industrial Average tracking ETF); and Cubes (the NASDAQ 100 tracking ETF) and find that their price deviation is stationary and predictable. Gastineau (2004) finds underperformance by ETFs when compared to index mutual funds (in terms of tracking error) and points out that the reason for the weakness is the formal specification of the ETF management policies; namely, the timing of declaration of creations or redemptions by investors. The presumption in the investment community is that ETFs, due to their nature of not requiring significant management involvement in the day-to-day running of the ETF portfolio, employ computers to monitor and clear any mispricing of the ETF.

We show that the policies to adjust the price imbalances via creation and redemption of ETF units are effective, but the price deviation is predictable and nonzero. The pricing deviation is specific for ETFs and does not exist in index mutual funds. Therefore, it can be considered an extra cost of trading and holding ETFs, in addition to the explicit transaction costs, such as brokerage and maintenance fees and bid-ask spread. The reason for the predictability of pricing deviation stems from the stationarity. The reasons for the pricing deviation being nonzero are the specific price discovery processes and dividend accumulation and distribution for this asset class. We conduct a study of the ETF pricing deviations and provide a new metric for the performance of ETF literature. Based on the extant research of the informative usefulness of security baskets, and of certain ETFs in particular, and the lack of comprehensive and general study of the pricing deviation of ETFs, it appears that there is a strong theoretical and empirical groundwork to justify extended research in this field.

2 Literature review and hypotheses

ETFs are either open-end funds or unit-trusts and are very similar to index funds, having as their most often mentioned benefit, cost reduction.1 Although similar to common stocks, ETFs have an additional advantage of not having short-selling restrictions as do regular stocks. Thus, they might be easier to use for hedging than regular stocks (Alexander and Barbosa 2005; Yu 2005). ETFs provide cheap diversification for both sophisticated and non-sophisticated investors and are considered to be popular because of their tax efficiency. Exchange traded funds pay quarterly dividends like regular stocks, but receive dividends constantly, which they keep in a non-interest earning account.2 The tax liability is incurred at payment of dividends, not when the ETFs actually receive the dividends from the companies in the index. Exchange traded funds do not incur capital gains as mutual funds due to infrequent readjustments of the portfolio and in-kind creation and redemption of stocks in their portfolio.

The Law of One Price and the "no-arbitrage" argument suggest that the price of a basket of securities, such as an ETF, should be equal to the sum of its components' prices. …