Exchange traded funds and market efficiency

Given the exponential growth of Exchange Traded Funds (ETFs) and their increasing importance in financial markets, I examine four issues related to these securities. I find that price discovery flows consistently from U.S. industry ETFs to their Canadian counterparts, while volatility spillovers are largely bi-directional. I also examine the informational efficiency of size-based U.S. ETFs and comparable CRSP portfolios. Variance ratio analysis demonstrates that return autocorrelations have diminished significantly over the past decade, while Granger causality tests reject the presence of lead-lag effects among size-based ETFs. However, volatility spills over from large firm ETFs to those of smaller firms, and these spillovers extend to ETF option implied volatilities. In the third chapter, a simple model of trading is developed for securities that are included in ETFs. These securities have become a significant factor in the volatility generating process of their largest component stocks since volatility spillovers from ETFs to their largest component stocks are economically significant. These spillovers are increasing in liquidity, the proportion of each stock held by the fund, deviations from net asset value, ETF flow of funds, and ETF market capitalization. Finally, Chapter Four examines the presence of common factors in the evolution of stock option implied volatilities. I analyze the implied volatilities of ETF options and those of their largest component stocks, and the results strongly suggest the presence of both a market volatility factor and an industry volatility factor. The drivers of implied volatility spillovers from ETFs to component stocks are strongly related to turnover in S & P 500 ETF options and those of SPDR industry sector ETFs.