Price Discovery in Emerging Market ETFs

Abstract

Over the last two decades, exchange traded funds (ETFs) have become a preferred investment vehicle to make directional market bets due to their low costs and high liquidity. Moreover, due to the arbitrage activities of authorized participants, prices of ETFs do not deviate materially from the prices of their underlying securities. As a result, ETFs may play a price discovery role such that systematic information is first reflected in these instruments and then transmitted to their underlying securities. We test this hypothesis by investigating the predictive relation between the returns of emerging market ETFs traded in the US and the returns to the emerging market equity indices that they track. In a sample that covers 18 countries, we find that ETF returns can predict one-day-ahead returns of their underlying indices. This relation is robust after controlling for the non-synchronicity between markets, serial correlation in index returns, and various determinants of aggregate returns. Moreover, the predictive relation is stronger during periods of higher volatility. We also find that an out-of-sample rolling window strategy outperforms investing in the market index several-fold in the majority of the markets.

Keywords: exchange traded funds, equity markets, price discovery, information efficiency

JEL Classification: G10, G11, G12, G14