Trading on ETF mispricings

Abstract

Prior literature has shown deviations between ETF prices and their net-asset-value (NAV) to exist. Fulkerson and Jordan (2013), p. 31, question "if there exists a true tradeable strategy" to exploit these inefficiencies. This paper implements a profitable daily long-short trading strategy based on price/NAV information and explicitly accounting for trading costs. For a sample of European sector ETFs, the authors analyze gross and net returns of a long-short trading strategy in the CAPM and Fama-French three-factor model. The authors document positive gross excess return for the long-short trading strategy in all sample periods, but net excess returns to be positive only between 2008 and 2010. The results document a profitable long-short trading strategy exploiting deviations between ETF prices and NAV and highlight the impact of trading costs in ETF markets. Due to the limited availability of historic trading cost data, the research uses a comparatively small sample size. The net profitability of long-short trading in ETFs is only found in times of high uncertainty in the stock market. The inclusion of trading costs enables a detailed comparison between gross and net returns in ETF trading, addressing potential limits to arbitrage.