Inefficiencies in the Pricing of Exchange-Traded Funds

Abstract

The prices of exchange-traded funds can deviate significantly from their net asset values, on average fluctuating within a band of about 200 basis points, in spite of the arbitrage mechanism that allows authorized participants to create and redeem shares for the underlying portfolios. The deviations are larger in funds holding international or illiquid securities where net asset values are most difficult to determine in real time. To control for stale pricing of the underlying assets, I introduce a novel approach using the cross-section of prices on a group of similar ETFs. Nevertheless, the average pricing band remains economically significant at about 100 basis points, with even larger mispricings in some asset classes. Active trading strategies exploiting such inefficiencies produce substantial abnormal returns before transaction costs, providing further proof of short-term mean-reversion in ETF prices.

Keywords: ETF, mispricing, arbitrage, NAV

JEL Classification: G10, G12, G14, G20, G23