- Title: INEFFICIENCIES IN THE PRICING OF EXCHANGE TRADED FUNDS
- Authors: ANTTI PETAJISTO
- Publication: FINANCIAL ANALYST JOURNAL, I Q 2017 (version here)
What are the research questions?
The article provides new empirical evidence on the state of market efficiencies in ETFs by studying the following questions:
- What is the magnitude of the ETF premiums across all US-listed ETFs and all underlying asset class and over time?
- In particular, what is the magnitude of “true” ETF premiums when stale NAVs are accounted for?
- What do these premiums depend on?
- What is the economic magnitude of the mispricings?
What are the Academic Insights?
The author studies a sample of 1,813 funds with an aggregate $ 1.97 trillion in assets over the period from 2007 to 2014. He finds that:
- While the average premium across all funds is 6 bps, the volatility of the ETF premium is 49 bps. This means that with 95% probability, a fund is trading at a premium between about -96 bps and +96 bps, or with a 192 bps band. Specifically, the author finds that international equities, international bonds, municipal and high yield bonds exhibit volatilities between 40-140 bps around NAVs. In terms of persistence, the premiums are short lived: half a day for equities and 2-3 days for non-Treasury bonds.
- By proposing a new methodology to deal with stale pricing ( it compares each ETF price deviation from its peer group mean), the author finds that this adjustment reduces the premiums on funds with international or illiquid holdings but still leaves them fluctuating within a pricing band of 100-200 bps, which is economically significant.
- Stale pricing explains part of the premiums but it is not a complete explanation. The author investigates bid-ask spreads but finds that they are relatively tight for commonly traded ETFs.
- The author calculates that the total premiums across all ETFs add up to $41 billion. When including the stale price adjustment methodology, the premium still add up to $20 billion. This is a proxy for costs of suboptimal timing of ETF trades ( and conversely, earnings from liquidity provisions). As a comparison, the entire ETF industry is estimated to earn $6 billion a year in management fees.
Why does it matter?
Some ETF funds compete by reducing a few basis points off their fees to bring them below 10 bps a year. Investors should be aware that by focusing only on the expense ratio, they may be overlooking a potentially bigger cost: the effect of an adverse premium on the transaction price.
This article provide evidence that trading ETFs with non-Treasury bonds or international securities as the underlying assets exposes the investor to the risk of poor trade timing because of premiums. The author proposes three methodology to improve the timing of the trade:
- compare the ETF’s price to the “intraday indicative value (IIV)- but in case of illiquidity or different time zone it may not be readily available
- utilize the peer-group approach proposed in the article
- look at the latest official premiums and trade only when markets have been flat for the last few days
The Most Important Chart from the Paper: