International Portfolio Diversification through ETFs.

Abstract

We examine whether for a US investor, investing in 15 country equity index ETFs traded on US exchange yields the same international diversification benefits as direct investments in these countries’ equity markets. We document that the tracking errors between the ETF’s NAV and market returns decrease with return horizons: they are large and significant at the daily horizon and become negligible at an annual horizon. Across countries, the tracking error magnitudes decrease as the overlap between the country’s market trading hours and those of the US markets increase. These tracking errors lead to substantial differences in the correlations estimated between the US markets and the countries’ ETF NAV and returns respectively, with similar patterns as the tracking errors: from large at the daily frequency to negligible at the quarterly frequency and decreasing as the trading hours overlap increases. We find that the tracking difference between a funds’ ETF return and NAV return is significantly related to the contemporaneous S&P500 return, the Volatility index, and foreign exchange, which reflect US market news or US investor sentiment, as well as fund specific variables such as Asset under management, Volatility of the fund, and Relative Net Creations/Redemptions. The study concludes that the tracking difference in the short-run arises primarily due to the difference in trading hours and does not persist in the long run, and hence that ETF are as efficient as direct investments to achieve international diversification.