Daily Changes to ETF Premiums Can Be Predicted in Advance: Morningstar

"In some cases, putting this knowledge to use for a single transaction could have covered the entire annual expense ratio of the ETF purchased," Davidson wrote. "For the ETF investor, the conclusions of this paper suggest that cost-conscious investors should seek to trade ETFs intelligently and patiently using information readily available today in order to avoid transacting at unfavorable prices tomorrow."

In addition, active ETF managers can create trading strategies using these relationships as indicators to generate abnormal returns before transaction costs, Davidson said.

Highlights of the report:

• A "naïve" trading strategy can be constructed to take advantage of the predictability of ETF premiums to generate abnormal returns with an average annualized Carhart alpha of 7.22% per year, ignoring costs.
• ETFs are highly efficient on average, but extremely inefficient at times. Being able to anticipate when inefficiencies in ETFs' pricing will occur matters for trade execution.
• ETF premiums tend to exhibit patterns that resemble those observed in the equity market, equity market volatility, and equity market liquidity.

Davidson's approach to modeling ETF premiums focuses on the day-to-day changes to an ETF's premium by creating a daily rebalancing long-short portfolio that goes long the ETF and short the underlying shares. The returns effectively represent an investment strategy that receives the ETF market return and pays the ETF NAV return each day.

Read Schwab Rolls Out 'Game-Changer': A Commission-Free ETF Platform at AdvisorOne.