A Cross-Country Analysis of Pricing Efficiency of Exchange Traded Funds

IntroductionOne of the most innovative, new investment vehicles that has emerged in the financial markets over the last two decades is Exchange Traded Fund (ETF), a security that tracks a stock index, a commodity or a basket of assets like an index fund, but trades on a stock exchange like an ordinary corporate stock . ETFs are hybrid investment instruments combining the advantages of both open-end mutual funds and closed-end funds. They combine the creation and redemption process of the former with the continuous stock market tradability of the latter. This is made possible by the unique trading mechanism of ETFs characterized by a dual structure, with a primary market open to institutional investors (known as fund Authorized Participants or APs) and a secondary market open to all investors. In the primary market, "in-kind" creation and redemption of ETF shares takes place in lots (called creation units) directly from the fund in return for a pre-specified stock basket consisting of shares comprising the underlying stock index in the same weightage as represented in the index. Whereas in the secondary market, such ETF shares created in the primary market can be bought and sold in cash on real time basis, with no limitation on order size, can be short sold or bought on margin in the same way like an ordinary corporate stock is traded.Since an ETF is traded in two markets, it has two prices: the Net Asset Value (NAV) of the shares, which forms the basis for creation and redemption in the primary market and the 'trading price' of the ETF shares which is determined by the market forces of demand and supply on the stock exchange. If the buying or selling pressure is high, these two prices may deviate from each other leading to significant premium or discount on such funds. However, through the possibility of 'in-kind' creation and redemption, market makers (APs) could absorb any such liquidity shock in the secondary market and arbitrage any significant deviation between price and NAV of ETFs either by redeeming outstanding shares or creating new shares in the primary market. For example, if the market price of ETF falls below its NAV (i.e., ETF is trading at discount in secondary market), APs can buy enough ETF shares in the secondary market to form a creation unit and at the same time, take a short position in the underlying index stocks. The APs can then redeem the ETF shares for the stock basket and close the short position at a profit (Deville, 2008). This buying pressure on ETF shares and selling pressure on underlying index stocks in the secondary market will thus correct the discounts on ETF shares. A reverse process may apply if an ETF is trading at a premium. In such case, the AP can make profit by purchasing the underlying index stocks sufficient to make a creation unit, tender them to fund in return for ETF shares and then sell these ETF shares on a stock exchange for a higher price. Thus, the unique in-kind creation and redemption process of ETFs enhances their pricing efficiency by ensuring that the departures between price and NAV of these instruments are not too large and any significant deviation is quickly arbitraged away.Though theoretically ETFs are expected to trade at prices that closely fit their NAVs, in practice this might not always be the case. There is an emerging literature examining the pricing efficiency of ETFs being traded in different parts of the world. However, most of these studies have concentrated on the US markets, with only a few of them focusing on the European, Australian or Asian markets. Also, these researches done on various countries have at times used different methodologies and no empirical study has yet compared the pricing efficiency of ETFs across countries using uniform performance criterion. This gap in literature provides rationale for the present study which makes a cross-country comparison of pricing efficiency of ETFs. More specifically, the study examines the presence as well as the persistence of premiums and discounts on ETFs traded in five dominant countries including India. …