Exchange traded funds

This dissertation examines the pricing behavior of exchange traded funds (ETFs) in three essays. (1) The Overreaction of International ETFs, (2) Fragmentation of Night Markets, and (3) The Impact of the Creation of the QQQ on the Underlying Securities. The overreaction study examines the role of information in global overreaction. Univariate analysis reveals that overreaction associated with informed events is less pronounced than with uninformed events following extreme price decreases. Further, positive firm-specific announcements are met with investor overreaction while negative firm-specific announcements are not. Finally, significant reversals of winners during bull markets relative to bear markets support the hypothesis that bull markets contribute to investor overconfidence and overreaction. The fragmentation study examines the cost of market fragmentation across day and night trading sessions. Using a sample of intraday transaction data for three ETFs, I show that night markets do not impound information available in net order flow to the same degree as day markets. Bid-ask spreads are wider at night and these costs are due to higher order processing costs, market maker rents and higher inventory holding costs. Furthermore, market concentration costs at night are associated with significantly higher spreads. The QQQ creation study investigates whether the creation of tradable baskets of securities affects the pricing efficiency and risk of the underlying securities. The results show that extreme price movements in the post-QQQ period are met with less pronounced corrections than in the pre-QQQ period, and that this pricing pattern does not hold true for the control sample. A decomposition of spreads finds that quoted spreads widen and effective spreads tighten in the post-QQQ period. Furthermore, though more heavily weighted components of the QQQ experience tighter spreads, this benefit is less pronounced in the post-QQQ period implying relative benefits to the less heavily weighted components. Cross-sectional analysis reveals that liquidity is directly related to pricing efficiency, but this relationship lessens in the post-QQQ period. The results also show that systematic risk for the underlying securities declines while total risk rises, though the control sample experiences a similar rise in total risk.

This dissertation investigates two fundamental questions related to how well exchange-traded funds that hold portfolios of fixed-income assets (bond ETFs) proxy for their underlying portfolios. The first question involves price/net-asset-value (NAV) mean-reversion asymmetries and the effectiveness of the arbitrage mechanism of bond ETFs. Methodologically, to answer the first question I focus on a time-series analysis. The second question involves the degree to which average returns of bond ETF shares respond to changes in factors that have been found to drive average returns of bond portfolios. To answer this question I shift the focus of the analysis to a cross-section asset pricing test. In other words, do bond ETF share prices track the value of their underlying assets, and are they priced by investors like bonds in the cross-section? The first essay concludes that bond ETF shares exhibit mean-reversion asymmetries when price and NAV diverge, along persistent small premiums. These premiums appear to reflect the added value that bond ETFs bring to the fixed-income asset market through smaller trading increments, greater liquidity, and the ability to buy on margin and sell short. The second essay concludes that market, bond-specific, and firm-specific risk factors can help to explain the variation in U.S. bond ETF average returns, but only size seems to be priced in the cross-section of expected returns. This is not surprising as the sample used in the asset pricing tests is limited to the period 2007-2010, which corresponds to the "great recession", and size has been interpreted in the asset pricing literature as a state variable that proxies for financial distress and is highly dependent on the phase of the real business cycle.