Overreaction of Exchange-Traded Funds During the Bubble of 1998-2002

Abstract

This study of overreaction is motivated by the unique characteristics of exchange-traded funds (ETFs), which should contribute to market efficiency. Since ETFs represent portfolios of stocks, they may not be as susceptible to short-term overreaction as individual stocks. In addition, they can be traded throughout the day and can be sold short, which might further limit potential overreaction. Yet, the tradability of ETFs may allow unusual pressure on ETF prices that is not initiated by price movements of all the component stocks. We find substantial overreaction of ETFs during normal trading hours (9:30 a.m. to 4 p.m.) and after hours, which presents opportunities for feedback traders. Extreme price movements of ETFs occur more frequently after hours. Yet, the after-hours correction of extreme price movements that occurred that day is more pronounced than the day correction of extreme stock price movements that occurred in the previous after-hours period, even after controlling for ETF type and other potential confounding effects. The degree of overreaction is also more pronounced for international ETFs.

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