Exchange Traded Funds pricing inefficiencies: Case of the ETFs tracking the Dow Jones Industrial Average, NASDAQ-100 and S&P 500 Indexes

This paper presents research on three popular US market Exchange Traded Funds (ETFs): Diamonds (DIA), Quebes (QQQQ) and SPDRs (SPY). Using the daily data for these three indexes tracking funds I investigate the price relationship among the ETFs and the indexes, finding that the difference between the price of the ETF and the index is not constant. I employ the Engel-Granger Error Correction Model (ECM) to examine how long it takes for the short term mispricings to revert back to the equilibrium. Based on the results of the ECM model I develop a trading strategy that is designed to capture the mispricings between the ETFs and the indexes they track. Further, I test this trading strategy with historical data. The strategy involves trading the Exchange Traded Funds and the Index Futures. The findings indicate that the strategy enhancing the ETF returns would have outperformed the simple ETF buy and hold strategy on a risk adjusted basis.