Commonality in ETF Mispricing and Contagion

A common component in the mispricing of ETFs can arise from limits to arbitrage. I find strong evidence of commonality among of international country ETFs. Differences in systematic risk between an ETF and its underlying index can explain some of this effect. While non-synchronicity alone cannot explain it, it does amplify the effect. I then investigate whether this commonality can be a channel of contagion between ETFs. Consistent with this hypothesis I find that extreme shocks to financial markets are followed by large changes in the systematic risks of ETFs. Extreme shocks to U.S. market returns or volatility generally amplify the overand under-exposure to subsequent U.S. and regional market movements that already exists in normal times. These findings imply not only that ETF returns are excessively volatile in comparison to their underlying index, but also that local risk matters for the pricing of these ETFs, particularly in adverse markets.