Essays on Exchange-Traded Fund Mispricing and Liquidity

In the first essay I investigate whether the high liquidity of ETFs attracts a clientele of short-term investors. I find that liquidity is an important determinant of fund flows, particularly at weekly and monthly horizons. I also investigate whether more liquid ETFs facilitates shorter-term trading. I document a liquidity clientele amongst institutional investors: i) their buys and sells are positively related to ETF liquidity, ii) liquidity is significantly more important for short- than for long-term investors, and iii) liquidity is inversely related to average holding periods. These findings are consistent with the idea that liquidity benefits short-term traders the most. In the second essay I show that changes in ETF misvaluation – as proxied by the return difference between an Exchange-Traded Fund and its underlying portfolio Net Asset Value – comove excessively across ETFs. Excess comovements are positive and highly significant across ETFs in matching investment styles, and negative and significant across distant styles. Further tests based on return reversals suggest that ETF premiums relative to NAV reflect misvaluation primarily in the ETF, rather than the NAV price, particularly for ETFs in more liquid styles (e.g. small-cap). Finally, the degree of return comovements is stronger for funds with high commonality in demand shocks and more attractive liquidity characteristics. These findings are consistent with the idea that liquidity can sometimes be detrimental to pricing efficiency, because liquidity attracts short-horizon noise traders with correlated demand for investment styles. The third essay investigates whether asset prices are exposed to local-trading induced misvaluation. My sample contains 2727 pairs of European ETFs from 15 different country pairs. Each ETF-pair has identical fundamentals, but is traded by investors from different countries. I document a strong country-specific factor in twin return differentials. This result holds from daily to monthly horizons, it is unrelated to exchange rates and it cannot be explained by liquidity differences. Consistent with local misvaluation in the stock market, I find a significantly positive relationship between twin return differentials and local stock returns, particularly at higher frequencies. Additional tests provide evidence against the alternative explanation that misvaluation is driven by similarities in information diffusion between twins.