The Limits of Arbitrage: Evidence from Exchange Traded Funds

Abstract

Exchange Traded Funds (ETFs) consistently trade away from their net asset value. In violation of market efficiency, these discounts vary substantially over time and are found to be significant in the explanation of future returns. Returns to simple strategies which incorporate information in the variation of discounts outperform buy-and-hold strategies by an annualized 15%, net of transaction costs, but only expose the investor to about one fifth the risk. ETFs, on average, are found to be about 17% more volatile than their underlying assets; 70% of the excess volatility can be explained by proxies for transaction and holding costs which inhibit successful arbitrage. The findings in this paper are consistent with noise trader models of costly arbitrage and are inconsistent with hypotheses of financial market efficiency.

Keywords: Limits of Arbitrage, Efficient Markets Hypothesis, Exchange Traded Fund, Closed-end Fund Puzzle, Noise Trader Model

JEL Classification: G10, G12, G14