Pricing Efficiency of Exchange Traded Funds in India

Y V Reddy,Pinkesh Dhabolkar

doi:10.15388/omee.2020.11.33

Y V Reddy, Pinkesh Dhabolkar

Open Access

https://doi.org/10.15388/omee.2020.11.33

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Abstract

Exchange traded funds (ETFs) have two prices, the market price and the net asset value (NAV) price. ETFs NAV price gets determined by the net value of the constituent assets, whereas the market price of ETFs depends upon the number of units bought or sold on the stock exchange during trading hours. As per the law of one price, the NAV and market price of the ETF should be the same. However, due to demand and supply forces, the market price may divert from its NAV. This price difference may have significant repercussions to investors, as it represents a cost if they buy overvalued ETF shares or sell undervalued ETF shares. Pricing efficiency is the speed at which the market makers correct the deviations between ETFs NAV and market price. The present study attempts to investigate the pricing efficiency of Indian equity ETFs employing an autoregression model over its price deviation, and also attempts to understand the lead-lag relationship between the price and NAV using the vector error correction model (VECM).

Highlights

Exchange-traded funds (ETFs) are unit investment trusts designed to mimic an underlying market index
The results indicate that all ETFs show a long-run relationship between the price and net asset value (NAV)
The present study contributes to the existing literature on ETFs in India, and tries to investigate the pricing efficiency achieved through the creation-redemption mechanism by the ETF market makers

Summary

Introduction

Exchange-traded funds (ETFs) are unit investment trusts designed to mimic an underlying market index. One can think of ETFs as index mutual funds that can be bought and sold in real-time at a price that changes throughout the day. The difference between these two asset classes is that unlike index mutual funds which trade at the end of the day at NAV, ETFs trade at real-time on stock exchanges, and investors can derive the benefit of trade-in ETF just like any ordinary stocks, which means they are easier to buy and sell quickly, if need be. One needs a demat account to invest in an ETF, whereas for an index mutual fund, one doesn’t need a demat account and may buy or sell the units directly from the mutual fund in small amounts

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Conclusion