Pricing Exchange Traded Funds

Exchange Traded Funds are equity issues of companies whose assets consist entirely of cash and shares of stock approximating particular indexes. These companies resemble closed end funds except for the unique feature that additional shares can be created or redeemed by a number of registered entities. This paper investigates the extent and properties of the resulting premiums and discounts of ETFs from their fair market value. Measured premiums and discounts can be misleading because the net asset value of the portfolio is not accurately represented or because the price of the fund is not accurately recorded. These features are incorporated into a model with errors-in-variables that accounts for these effects and measures the standard deviation of the remaining pricing errors. Time variation in this standard deviation is investigated. Both domestic and international ETFs are examined, each from an end-of-day perspective and from a minute-by-minute intra-daily framework. The overall finding is that the premiums/discounts for the domestic ETFs are generally small and highly transient, once mismatches in timing are accounted for. Large premiums typically last only several minutes. The standard deviation of the premiums/discount is 15 basis points on average across all ETFs, which is substantially smaller than the bid-ask spread. For international ETFs, the findings are not so dramatic. Premiums and discounts are much larger and more persistent, frequently lasting several days. The spreads are also much wider and are comparable to the standard deviation of the premiums. This finding is insensitive to the timing of overlap with the foreign market, the use of futures data, or different levels of time scale. In fact there are only a small number of trades and quote changes in a typical day for most of these funds. An explanation for this difference may rest with the higher cost of creation and redemption for the international products. Nevertheless, when compared with closed end funds where there are no opportunities for creation or redemption, the ETFs have smaller and less persistent premiums and discounts. The implication is that the pricing of ETFs is highly efficient for the domestic products and somewhat less precise for the international funds since they face more complex financial transactions and risks.