The Rise in Equity Exchange Traded Funds (Etfs): The Case of Momentum?

INTRODUCTION Exchange traded funds (ETFs) are Trust funds and basket of securities designed to track an index. ETFs add the flexibility, ease, and liquidity of stock trading to the benefits of traditional index fund investing. The world global financial market has witness a substantial increase in equity exchange traded funds (ETFs) since its inception in the early 1990's to date. These increases are more prevalent in the US. Recently, as early as 1993, the State Street Global Advisor listed the first ETF on the American Stock Exchange. According to Fund International (2004), US domestic equity ETFs grew at an annual compounded rate of 38.3% from 2000 to 2004. Outside the US, similar trends were observed, most especially in UK, Europe, Asia and South Africa. The reasons for the growth of ETFs could be attributed to its characteristics. ETFs tend to offer greater tax benefits due to the fact that they generate fewer capital gains as a result of lower turnover of the securities that comprises their portfolios. The sale of ETFs securities only reflects the changes in its underlying index. Since ETFs are index based, they are unlikely to experience high management fees. Furthermore, the composition of ETFs as a basket of securities provides diversification inherently across an entire index. ETFs can be traded at any time while the exchange is open. Like other types of funds, arbitrage forces the price of ETFs to be aligned with the net asset value, thereby limiting its tracking error. ETFs are structured as a trust to minimize tax distribution in most cases. The increasing trends in ETFs have not abated despite the downturn of economic activities. In her recent paper, Mitchell (2010), noted that some portion of the ETF market have withstood the recent slowdown of economics fluctuations. She observed that from January through the end of April 2010, investors confidence in an economic recovery has led to strong performance in equity exchange traded funds. LITERATURE REVIEW Based on size, trading volume, returns and fund price performance, Madura and Ngo (2008), examined whether ETFs exhibited pricing discrepancies. They formed decile of portfolios over 93 months (January 1997-September 2004) in which the beginning of each month was considered the portfolio formation month. For eight different holding periods within each decile, they obtained the abnormal holding period returns. The same decile portfolio applied to apportioned size was also used for trading volume and fund price performance. They concluded that ETFs do not experience momentum. That, the performance of ETF's is inversely related to size, while ETFs with lower trading volume are more likely to be mispriced or subject to liquidity premium. Most literatures look at the source of price momentum either as driven by the stock specific industry or by individual-stock momentum. Scowcroft and Sefton (2005), confirmed that price return momentum is driven by industry momentum. They however postulated that momentum occur in medium cap industry. Jong and Rhee (2008), looked at the abnormal returns with momentum and contrarian strategies using exchange traded funds. Their study found that investment in ETFs provides abnormal return which exceeds transaction cost. And that the presence of abnormal return exist after using Fama and French (1993) three factor-factor model to adjust for risk. In that case, portfolios of ETFs that either buy the winners and short the losers or buy the losers and short the winners could earn abnormal returns. However, it is pertinent to note that all US ETFs are passively managed to track an index, not actively managed to time the market or beat the market by loading up on high momentum stocks. Yet in spite of this disadvantage of actively managed mutual funds, ETFs provided economically and statistically significant abnormal returns to contrarian strategies of buying the loser ETFs and shorting the winner ETFs with formation and holding periods of one day and one week, and to momentum strategies of buying the winners ETFs and shorting the losers ETFs with formation and holding period from 4 to 39 weeks, according to the authors. …