The present study investigates the issue of excess volatility in index exchange-traded funds (ETFs) in India and analyses how well the costly arbitrage theories apply to this segment of the market. We find that the returns of the average ETF are 110 per cent more volatile as compared to the returns of the underlying portfolio which suggests that public trading introduces an additional layer of volatility in ETFs. Factors that limit arbitrage by making it costly for the arbitrageurs to remove the price-net asset value (NAV) deviations explain about 67 per cent of the variation in excess volatility. The cointegration analysis provides evidence of a long-term equilibrium relationship between price and NAV. Vector error correction model (VECM) results suggest that NAVs lead prices to restore this equilibrium in case of short-run deviations. The analysis also revealed that ETF returns are predictable on the basis of past deviations and may be used to generate returns which are significantly greater than those of a buy-and-hold strategy. Our results are in agreement with the theory of costly arbitrage and are inconsistent with the construct of efficiency in financial markets.
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