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Exchange traded funds, size-based portfolios, and market efficiency

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Abstract

We examine the informational efficiency of size-based US exchange traded funds (ETFs) and comparable Center for Research in Security Prices portfolios. ETFs are better suited for market efficiency tests since they avoid potential asynchronous trading problems, and their negligible bid-ask spreads greatly diminish noise due to the bid-ask bounce. Variance ratio analysis demonstrates that return autocorrelations have diminished significantly over the past decade. Granger causality tests reject the presence of lead-lag effects among size-based ETFs. However, volatility spills over from large firm ETFs to those of smaller firms, and these spillovers extend to ETF option implied volatilities.

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Notes

  1. See, for example, Ben-David et al. (2012), Bradley and Litan (2010), Chordia et al. (2011) and Easley et al. (2011).

  2. See also Cochrane (2008), Conrad and Kaul (1988), Fama and French (1988) and Keim and Stambaugh (1986), among others.

  3. The grand average of yearly closing bid-ask spreads for the ETFs considered in this study is 0.073 %, but only 0.021 % since 2003, and even smaller in recent years.

  4. An online search for studies that reference Lo and Mackinlay (1988) results in 2,260 citations, 277 of which occurred since 2010, so their findings and methodology remain as relevant as ever.

  5. See, for example, Griffin et al. (2010), O’Hara and Ye (2011) and Saffi and Sigurdsson (2011).

  6. See, for example, Conrad and Kaul (1988) and Keim and Stambaugh (1986).

  7. Although the small cap Russell ETF (IWC) is correlated with the smallest CRSP portfolio at a slightly higher level than IWM (0.95 vs. 0.87), data for this ETF is available only since its inception in August 2005. We use IWM rather than IWC since it has a longer time-series available. IWC is highly correlated with IWM and yields similar results.

  8. For evidence of this phenomenon, see Goyal and Santa-Clara (2003), Haugen (2010) and Hibbert et al. (2008).

  9. The figures are even lower for NYSE/AMEX firms. The mean (median) effective bid-ask spread for these stocks is 0.76 (0.34) % in 2007 for these firms compared to a mean (median) of 1.64 (0.94) % in 1999.

  10. See, for example, Avramov et al. (2006), French and Roll (1986), Haugen (2010) and Malinova and Park (2011).

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Authors and Affiliations

  1. Department of Finance, College of Business, University of Texas at San Antonio, San Antonio, TX, 78249, USA

    Palani-Rajan Kadapakkam

  2. Sam and Irene Black School of Business, Penn State Erie, Erie, PA, 16563, USA

    Timothy Krause

  3. Department of Finance, College of Business Administration, University of Missouri–St. Louis, St. Louis, MO, 63121, USA

    Yiuman Tse

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  1. Palani-Rajan Kadapakkam
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  2. Timothy Krause
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  3. Yiuman Tse
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Correspondence to Yiuman Tse.

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Kadapakkam, PR., Krause, T. & Tse, Y. Exchange traded funds, size-based portfolios, and market efficiency. Rev Quant Finan Acc 45, 89–110 (2015). https://doi.org/10.1007/s11156-013-0429-x

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