Liquidity, style investing and excess comovement of exchange-traded fund returns

• Liquidity is attractive to short-term noise traders who engage in style investing.
• Shocks to ETF misvaluation comove positively with other ETFs in similar styles.
• ETF return reversals suggest that the source of misvaluation is the ETF, and not the NAV.
• ETFs with more desirable liquidity characteristics have higher excess comovements.

This study shows that exchange-traded fund (ETF) misvaluation – based on return differentials between ETFs and their net asset values (NAV) – comove excessively across ETFs. Excess comovements are positive (negative) and significant across ETFs in similar (distant) investment styles. Further tests based on return reversals suggest that misvaluation stems primarily from the ETF, rather than the NAV price. Excess comovements are greater for funds with high commonality in demand shocks and attractive liquidity characteristics. These findings are consistent with the idea that the high liquidity of ETFs attracts a clientele of short-horizon noise traders with correlated demand for investment styles.