Market efficiency and performance dynamics of International Exchange-Traded Funds : A thesis submitted in partial fulfilment of the requirements for the Degree of Doctor of Philosophy at Lincoln University

Abstract

Despite persistent economic and political volatility in the world, the Exchange-Traded Fund (ETF) industry continues to experience popularity and growth since the invention of the first ETF. This growth of the ETF industry is not just in scale but in sophistication as well. A variety of ETFs now cater for different investment needs of the global investors and International ETF is one of the sophisticated types of ETF which is designed to mirror the performance of its foreign benchmark index. International ETFs promise some very distinguishing features to investors such as continuous trading, higher international diversification, lower management fee and higher tax efficiency. Majority of the International ETFs are listed in the US and tracks the indices of foreign markets which has non-synchronous trading hours with the US market. The asynchronous trading hours between the markets of Exchange-Traded Funds (ETFs) and their benchmarks not only make it difficult to apply full replication strategy but also make the creation/redemption process (the arbitrage mechanism) ineffective and consequently effects the market efficiency and distress the performance of international ETFs. Despite the exponential growth of ETF industry in general and international ETFs in particular, the market efficiency and performance dynamics of international ETFs are still under-researched. This study evaluates (1) the market efficiency by analysing the random behaviour and calendar anomalies in the International ETFs; and (2) the performance dynamics of International ETFs by analysing their returns and return volatilities, tracking abilities and pricing efficiencies. The study includes a sample of 56 US-listed International ETFs offering the exposure of Asia-Pacific and European markets. Next, the study employs Lo and MacKinlay (1988) individual variance ratio and Chow and Denning (1993) multiple variance ratio to examine whether International ETFs follow a random walk. ARMA-GARCH model is used to investigate the presence and persistence of calendar anomalies in the international ETF returns over time. We estimate the return and volatility in trading price and NAV to distinguish their behaviour; and to compare the return volatility during the trading hours (intraday) and non-trading hours (i.e. overnight), we also calculate and compare return and volatility during intraday and overnight periods. Moreover, to evaluate the risk-adjusted performance, we employ capital asset pricing model (CAPM) model by regressing trading price returns and NAV returns of International ETFs on their corresponding benchmark returns after adjusting both with a risk-free return. Tracking errors in trading price returns and NAV returns are estimated using the two methods (1) the absolute difference in ETF and its benchmark returns and (2) the standard deviation of the difference in ETF and its benchmark returns; and second-order autoregressive model by regressing the tracking errors on the values of their two lagged days. To measure the pricing inefficiency of International ETFs, we use two methods (1) percentage change in closing price of ETFs and NAV and (2) OLS by regressing trading price of ETFs on its NAV; and to examine the persistence of pricing inefficiency in International ETFs, we regress the estimated price deviation on its two day lagged values using the second-order autoregressive model. The findings of this study are equally useful for investors and practitioners interested to understand the market efficiency and performance dynamics of International ETFs. As a pioneer study, it not only fills the research gap in the literature of international ETFs but it also contributes to the existing literature on random walk hypothesis, calendar anomalies, efficient market hypothesis and adaptive market hypothesis by investigating these phenomenon using a relatively new asset class. The conception of random walk and calendar anomalies enable investors and practitioners to make the most of any informational inefficiency in the returns of international ETFs by applying various optimal investment strategies. The comprehensive findings on the behaviour of risk and return, tracking error and pricing inefficiency help investors and practitioners to better understand the trading mechanism and be adaptive in response to the performance metrics explored in this study.