Chapter 5: Overreaction of Exchange-Traded Funds During the Bubble of 1998–2002
Jeff Madura and Nivine Richie INTRODUCTION The phenomenon of under/overreaction cuts directly at the heart of market efficiency. If markets are truly efficient, all relevant information should be immediately and fully reflected in the stock price. Underreaction indicates this is not the case; information is instead incorporated over a period of time. Overreaction, on the other hand, suggests that stock prices consistently overshoot, and their reversals can be predicted from past price movements. A study of broad market indices by Richards (1997) finds evidence of overreaction. In the past, such inefficiencies were not exploitable because indices were not actively traded. Today, however, the advent of exchange-traded funds (ETFs) makes further study appropriate. In contrast with stock market indices of the past, ETFs offer investors the opportunity to actively trade the market. In the past, investors who sought to invest in the ‘market’ could choose mutual funds that mirrored their index of choice. However, mutual funds investors can only transact once per day at the closing net asset value (NAV) set by the fund manager. Unlike mutual funds, ETFs are traded on exchanges throughout the day at prices set by the market. They also allow investors to sell securities short without the constraint of the ‘uptick’ rule. ETFs should be properly priced by the market since they are not subject to constraints on intraday trading and short sales. This chapter attempts to determine whether ETFs are subject to particular forms of overreaction. We also assess whether the pricing behavior of ETFs...
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