An ETF Premium Puzzle and a Market Segmentation Explanation

This paper shows that exchange traded funds (ETFs) persistently trade at a premium to net asset value (NAV) and that market segmentation can explain this puzzling regularity. Tracking error standard deviation is used as the measure of market segmentation. ETFs with larger tracking error standard deviations trade at higher premiums, consistent with the notion that investors are willing to pay a premium to receive liquidity and diversification benefits from holding ETFs rather than the underlying securities directly. These results are robust to investor sentiment effects. Further tests validate that tracking error standard deviation has the desirable properties of a market seg-mentation measure