Exploitable Cross Autocorrelations among iShares

Abstract We extend the evidence on exploitable cross autocorrelations in equity returns by examining whether individual investors can exploit cross autocorrelations in Standard and Poor's Depository Receipts and iShares international index funds of 17 countries. Empirical testing reveals that iShares exhibit predictable elements that could be exploited by investors on a before transaction cost basis. We then compute bid-ask spreads and liquidity spreads to determine their affect on the risk-adjusted returns of the trading strategies. We find that transactions costs are generally high and that investors would need to be very cautious in placing trades to exploit returns patterns. © 2007 Academy of Financial Services. All rights reserved. Jel classifications: s: G12, G14, G15 Keywords: ETFs; iShares; Trading rules 1. Introduction iShares are Exchange Traded Funds (ETFs) that are designed to track Morgan Stanley Capital International (MSCI) country indexes. These ETFs combine the benefits of diversification from index investing with the flexibility of investing in common stock. These investment vehicles are essentially index funds that are listed on an exchange, priced and traded intraday, and allow investors to buy or sell shares based on the collective performance of an entire portfolio. ETFs and iShares have become increasingly popular with investors because they are designed to replicate the holdings, performance, and yield of their underlying index. ETFs and iShares are tax efficient because they generate few realized capital gains. Because ETFs and iShares are not actively managed, they only sell securities to reflect changes in the underlying index. Exchange trading further enhances their tax efficiency because investors who want to liquidate shares sell them in the secondary market. Because of this structure, ETFs and iShares, unlike mutual funds, are not required to sell securities to meet redemptions. Thus, this structure eliminates the generation of trading-related capital gains that would be taxable for remaining investors. ETFs and iShares also have significantly lower annual expense ratios than mutual funds which is due, in part, to passive management.1 Additionally, because they are exchange traded, ETFs and iShares can be bought and sold at intraday market prices, purchased on margin, sold short, and traded using stop and/or limit orders. The structure of ETFs and iShares makes them suitable for exploiting predictable patterns in security returns. Of particular interest in this study is the ability to exploit cross autocorrelations in returns. Hamao, Masulis and Ng (1990) report "spillover effects" between the United States and international markets. The practical significance of this finding is that markets behave in a predictably way and that a large positive (or negative) return in one market today could predict a large return in another market tomorrow. If this cross autocorrelation is found with iShares, it may be exploitable by individual investors. Using 1,961 daily return observations of Standard and Poor's Depository Receipts and 17 iShare international index classes, we explore the potential exploitability of returns. Empirical testing uses cross autocorrelations and the Granger causality method to examine daily returns of iShares. We then develop a trading strategy that attempts to exploit statistical relationships. Finally, we test the trading strategy on a holdout sample to ascertain whether it dominates a buy-and-hold strategy in terms of raw and risk-adjusted returns. We contribute to existing literature by (1) examining whether the exploitable patterns observed among United States and foreign stocks are observed in the returns of the ETFs and iShares that represent equity indices in the United States and 17 foreign countries, (2) determining whether return patterns are exploitable on a before transaction cost basis, and (3) examining bid-ask spreads and liquidity spreads to ascertain whether return patterns are exploitable after considering transactions costs. …