Short-term overreaction in equity ETFs following extreme one-day returns

Authors

DOI:

https://doi.org/10.1590/1808-057x201807630

Keywords:

equity ETFs, overreaction, short-term reversal, normal hours - after-hours return, price predictability

Abstract

This paper investigates the short-term price predictability of US equity Exchange Trade Funds (ETFs) in reaction to one-day extreme returns. We also assess the cross-section features associated to price overreaction following extreme price movements. The literature on the short-term overreaction of ETFs is rather scarce. Furthermore, existing studies tend to focus on delimited historical periods, which makes their results difficult to generalize. Our paper fills this gap by considering a comprehensive sample of ETFs over an extended period of time. In addition, we are the first to study the effect of the prevailing market trend and of liquidity on the patterns of overreaction and subsequent price reversal of ETFs. Being the major ETFs the most actively traded equity securities on the US stock exchanges, their performance and characteristics are of interest by themselves. Our findings suggest that market regulators should concentrate their resources on overseeing the ETF pricing that occurs after-hours. For market practitioners, our results indicate the existence of profitable market opportunities after large price movements. In the present study, we tested the significance of the mean returns for the period immediately after extreme returns. We also conducted a multivariate analysis where the price reversal was regressed against the cross section features of the ETFs under study. We contribute to the literature on ETF price formation as we document, for the first time, the existence of a stark contrast in the reaction to extreme price movements in these assets during normal hours and afterhours periods. On average, the extreme returns that occur in the after-hours period represent an overreaction, leading to a price reversal in the following period. In addition, we show that both tax-motivated trading and noise trading play a role in the pattern of ETF overreaction and reversal.

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Published

2019-08-21

Issue

Section

Original Articles

How to Cite

Lobão, J., & Costa, A. I. (2019). Short-term overreaction in equity ETFs following extreme one-day returns. Revista Contabilidade & Finanças, 30(81), 352-367. https://doi.org/10.1590/1808-057x201807630