ISSUES IN FINANCIAL MARKETS

Indian Exchange Traded Funds

Relationship with Underlying Indices
Vinodh Madhavan, S Maheswaran

This paper seeks to model the long-run relationship

between Indian exchange traded funds or ETFs and their
underlying indices. The findings indicate that the
relationship fails to fully explain the price dynamics of
Indian ETFs. In other words, Indian ETFs serve as an
imperfect hedge for investors who have exposure to
respective underlying indices.

The authors acknowledge the comments by an anonymous referee of

this journal on a previous version of this paper.
Vinodh Madhavan (vmadhavan@imt.edu) teaches at the Institute of
Management Technology, Ghaziabad, Uttar Pradesh. S Maheswaran
(mahesh@ifmr.ac.in) teaches at the Institute for Financial Management
and Research, Sri City, Chittoor, Andhra Pradesh.

142

1 An Overview

xchange traded funds (ETFs) are publicly traded funds

that invest in equities, currencies, commodities, or bonds.
Ever since the birth of the first ETF in the United States
(US) in 1993, ETFs have garnered unprecedented traction
among market participants who are constantly looking for avenues for portfolio diversification. ETFs have revolutionised
the investment landscape as they enjoy the best of both worlds.
Like close-ended funds (CEFs), ETFs are traded in an exchange,
thereby offering opportunity for investors to obtain exposure
to a portfolio of assets on a real-time basis. In addition, like openended funds, in-kind creation/redemption of fund units in exchange for predefined underlying portfolio baskets is possible
in the case of ETFs. Moreover, ETF expense ratios are generally
lower than those of mutual funds and also, ETFs are relatively
more tax efficient than traditional mutual funds.
Since ETF is an investment fund, it needs to be launched by
an asset management company (AMC) under the provisions of
Investment Company Act of 1940 in US. Further, owing to
structural differences, ETFs call for exemptive relief from
certain provisions of the Investment Company Act, unlike
traditional mutual funds. These exemptions include (i) the
ability to redeem shares only in large blocks; (ii) the use of
in-kind transactions for creation and redemption of ETF units;
and (iii) gateways for other investment companies to purchase
shares of funds in excess of Investment Company Acts fundof-fund regulations. Funds that apply for these exemptive
reliefs would not only incur substantial legal costs but would
also have to wait anywhere from several months to years, so as
to obtain exemptive relief.
The AMC that initiates requisite proceedings in connection
with introduction of a new ETF serves as its sponsor. The
sponsor sets the investment objective for the ETFs, decides the
constituents of the ETF, enlists authorised participants for the
ETF and creates ETF units that are subsequently delivered to
authorised participants. An authorised participant can order
for creation and redemption of large blocks of ETF shares
directly from the sponsor (AMC). Such large blocks of ETF
shares are referred to as creation units. When it comes to
creation, the authorised participant has to deposit a basket of
underlying securities to the ETF sponsor so as to receive
an ETF creation unit. Similarly, an authorised participant can
redeem ETF creation units for a basket of underlying securities.
This mechanism that facilitates creation and redemption
of ETF creation units is referred to as in-kind transaction.
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ISSUES IN FINANCIAL MARKETS

Net AUMs (in billions)

Since all ETF transactions happen on an in- Figure 1: Growth Trajectory of Net AUMs across US-registered Investment Companies
$20,000
kind basis, it is the authorised participants
and not the ETF sponsor that bears the cost
UIT ETFs
Close-ended
funds Mutual
funds
ETFs
Close-ended funds
Mutual funds
$18,000
of trading as well as volatility risk of ETF
$16,000
units and its underlying securities. In addition, since in-kind redemptions do not create
$14,000
taxable gains, ETF trades per se, between
sponsor and authorised participants, have
$12,000
no tax consequences. ETF units issued to au$10,000
thorised participants are subsequently
bought by trading members, who in turn fa$8,000
cilitate secondary market activity in ETF
$6,000
creation units by trading these ETF units
with the broader public.
$4,000
Since ETFs serve as a gateway for investors
to (i) obtain exposure to the broader market
$2,000
and (ii) to hedge against prior exposure in
$0
the underlying indices, robust econometric
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
modelling of ETF returns that takes into Source: Investment Company Institute.
account the long-run association of ETFs with their respective traditional mutual funds, ETFs, and UITs in US, the readers
underlying indices, plays an instrumental role in arriving at may refer to Figure 1.
ETF-centred investment decisions in general and ETF-centred
As of 31 December 2015, registered Indian investment
hedging decisions in particular. Consequently, the central in- schemessuch as and limited to, money market schemes, gilt
tent behind this essay is to model the long-run relationship be- schemes, debt-oriented schemes, equity-oriented schemes,
tween Indian ETFs and their respective underlying indices, and balanced schemes, gold ETFs, ETFs other than gold, and fund of
to subsequently capture this long-run relationship between Indi- funds investing overseashad a total AUM of Rs 12.74 lakh
an ETFs and their underlying indices as part of our broader ef- crore. An overwhelming proportion (98.46%) of AUMs pertain
forts to model Indian ETFs per se. Should the price dynamics of to traditional mutual funds that issue money market schemes,
the Indian ETFs be fully captured by the long-run relationship gilt schemes, debt-oriented schemes, equity-oriented schemes,
between Indian ETFs and their respective underlying indices, and balanced schemes. The proportion of AUMs held by gold
Indian ETFs would serve as an ideal hedge for investors who ETFs, ETFs other than gold, and fund-of-funds investing
have prior exposure to the underlying indices. On the other overseas scheme were 0.45%, 0.93% and 0.16% respectively.
hand, should the price dynamics of the Indian ETFs be partially As we write this essay in January 2016, a total of 30 equity
captured by the long-run relationship between Indian ETFs ETFs, 13 debt ETFs, two world indices ETFs and two debt ETFs
and their respective underlying indices, Indian ETFs would are listed in the National Stock Exchange of India. For an
serve as an imperfect hedge for investors who have prior overview of AUMs across different registered investment
schemes and for an investor-wise break-up of such AUMs, the
exposure to the underlying indices.
Having introduced readers to ETFs in general and the contri- readers may refer to Table 1 and Table 2 (p 144) respectively.
What is evident from Figure 1 and Tables 1 and 2 is that the
bution of this essay, we touch upon the stylised facts pertaining to ETFs in Section 2. Subsequently, we offer a snapshot of Indian ETF industry is nowhere near its global counterpart,
the scholarly literature on ETFs in Section 3, while we devote when it comes to size. The first Indian ETFNIFTYBEESwas
Section 4 in its entirety for an econometric investigation of the launched in 2002 and the indian ETFs growth story has been
relationship between Indian ETFs and their respective under- rather tepid in its first decade. Having said so, to a larger
extent, the growth story of Indian ETFs mirrors its global
lying indices. Lastly, we conclude in Section 5.
Table 1: Scheme-wise Assets Under Management (AUM) in India as of
31 December 2015

2 Stylised Facts

As of 31 December 2014, US-registered investment companies,

such as and limited to, open-ended mutual funds, close-ended
mutual funds, ETFs, and unit investment trusts (UITs), had
$18.2 trillion assets under management (AUM) and managed
24% of household financial assets. As of 31 December 2014,
there were 1,574 active ETFs and they had total AUM of $2.123
trillion. An overwhelming proportion of US ETF AUMs comprised equity holdings (83.7%), while the rest comprised
hybrid and bond holdings (16.3%). For a visual illustration
of the co-evolution of net AUMs with respect to CEFs,
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Type of Schemes

AUMs (Rs Crore)

AUMs (%)

Liquid/money market
Gilt
Debt-oriented
Equity-oriented
Balanced
Gold ETF
ETFs (other than gold)
Fund-of-funds investing overseas
Total AUMs

2,32,970.05
17,463.16
5,56,863.52
4,05,662.28
42,192.67
5,773.39
11,886.94
2,022.50
12,74,834.5

18.27
1.37
43.68
31.82
3.31
0.45
0.93
0.16
100.00

Source: Association of Mutual Funds in India (AMFI).

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ISSUES IN FINANCIAL MARKETS

counterpart. It took 11 years for global ETFs to reach AUM of $1

trillion (Lokeshwarri and Nalinakanthi 2015). Consequently,
the widely anticipated inflection point for Indian ETF growth
story is not that far way. At this juncture, we would like to
point out two notable events that have led to resurgence in
investors interest in Indian ETFs. First, the growing demand
for gold in India has translated into higher investments in gold
ETFs owing to the ease of storage and the higher liquidity of
gold ETFs in relation to physical gold. Second, the Indian
governments decision to divest its stakes in central public
sector enterprises (CPSE) has led to a surge in interest of CPSE
ETFs. Having presented the stylised facts pertaining to ETFs in
US and India, we devote the next section for a brief overview of
scholarly literature on ETFs.

in connection with redemption/creation process owing to

prohibition of trading by foreigners, and the long time lapse
between placing of the order for creation/redemption and the
time at which the order is actually executed.
Country ETFs are a sub-sector of the ETF landscape and are
designed to track the stock market indices of foreign countries.
Country ETFs are traded in the US during local trading hours,
while the underlying index would be traded in a foreign
country. Such country ETFs offer an opportunity for US market
participants to gain an exposure to foreign markets during US
trading hours.
Engle and Sarkar (2006) found mispricing in domestic ETFs
in relation with their underlying indices that lasted for several
minutes, as opposed to the mispricing in the case of international

Table 2: Scheme-wise, Investor-wise AUMs in India as of 31 December 2015

Types of Schemes

Investor Classification

Liquid/money market Corporates

Banks/FIs
FIIs
High net worth individuals
Retail
Total
Gilt
Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total
Debt-oriented
Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total
Equity-oriented
Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total

AUM (Rs Crore)

AUM (%)

2,01,036.57
9,319.93
432.26
18,294.62
3,886.67
2,32,970.05
10,349.56
140.48
504.66
5,487.74
980.72
17,463.16
3,18,212.30
9,777.14
8,374.04
1,74,886.34
45,613.70
5,56,863.52
61,656.36
1,550.74
4,164.14
1,30,338.41
2,07,952.64
4,05,662.28

86.29
4.00
0.19
7.85
1.67
100
59.27
0.80
2.89
31.42
5.62
100
57.14
1.76
1.50
31.41
8.19
100
15.20
0.38
1.03
32.13
51.26
100

Types of Schemes

Investor Classification

Balanced

Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total
Gold ETF
Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total
ETFs (other than gold) Corporates
Banks/FIs
FIIs
High net worth individuals
Retail
Total
Fund-of-funds
Corporates
investing overseas
Banks/FIs
FIIs
High net worth individuals
Retail
Total

AUM (Rs Crore)

AUM (%)

7,476.69
43.88
35.65
20,310.57
14,325.89
42,192.67
2,811.82
3.07
2.76
866.92
2,088.81
5,773.39
7,899.63
2,221.77
139.76
969.89
655.89
11,886.94
394.84
0.01
0.00
1,113.59
514.06
2,022.50

17.72
0.10
0.08
48.14
33.95
100.00
48.70
0.05
0.05
15.02
36.18
100.00
66.46
18.69
1.18
8.16
5.52
100.00
19.52
0.00
0.00
55.06
25.42
100.00

Source: Association of Mutual Funds in India (AMFI).

3 Literature Review

The in-kind creation and redemption process in the case of

ETFs offers a gateway to exploit arbitrage opportunities that
arise owing to deviations (if any) between ETF prices and the
net asset values (NAVs) of the underlying basket of securities.
Should the creation and redemption process for ETFs work
efficiently, then there should not be any persistent mispricing
between ETFs and their underlying basket of securities. Having
said so, the creation/redemption process for ETFs is not the
same across all funds.
For domestic ETFs, the creation/redemption order placed
during the day is executed at the end of the day, while for
some country (international) ETFs, the process becomes
complicated owing to a variety factors such as, but not limited
to, substantial taxes that need to be paid at the time of
transfer of shares in connection with redemption/creation
process, cash settlement of transactions made by foreigners
144

ETFs that lasted for three hours or longer. Similarly, Delcoure and
Zhong (2007) found international ishares ETFs trading at a
premium for one or two days, despite controlling for transaction
costs and time zone errors. Further, Elia (2011) examined Asian
ETFs trading in Italian markets and obtained results that are in
line with Delcoure and Zhong (2007).
Tse and Martinez (2007) examined the price discovery process
and information transmission mechanism of 24 international
ishares funds and found ishares to reflect all fundamental
information of their underlying stocks, notwithstanding their
limited diversification benefits. Furthermore, Hughen and
Mathew (2009) found that country ETF returns are more closely
related to their portfolio returns than CEFs returns, and that
ETFs and CEFs under-react to the NAV returns, but overreact to
the domestic stock returns. The latter observation is in an
extension of Kim et als (2000) work, which showed that
American Depositary Receipts (ADR) prices under-react to
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ISSUES IN FINANCIAL MARKETS

NAVs and overreact to the domestic stock market. In addition,

Levy and Lieberman (2013) distinguish between intraday and
inter-day processes that govern the dynamics between ETF
share prices, NAV, underlying index prices, exchange rate, and
the domestic stock market. They found that ETF returns are
increasingly impacted by domestic stock market returns
during non-synchronised trading hours, while transition to
a synchronous trading time frame leads to a regime shift in
the effect of domestic stock market returns on the ETFs,
whereby the ETF returns are then mostly driven by underlying NAV values as opposed to domestic stock market returns.
Recently, Hilliards (2014) examination of mispricing associated with ETFs using the OrnsteinUhlenbeck process augmented with jumps uncovered no mispricing in the case of
local US ETFs and higher long-term mean premium and lower
speed of adjustments in the case international equity ETFs
and bond ETFs.

On the Indian front, Prasanna (2012) examined the characteristics, growth pattern, and the performance of 82 ETFs
using data envelopment analysis and found domestic ETFs
and overseas fund-of-funds to be efficient. Further Khanapuri
(2012) examined the relationship between ETFs and their
underlying indices using vector autoregression, and found
that co-movements are stronger in equity ETFs and are nonexistent in commodity ETFs.
Having offered a brief overview of prevailing scholarly
literature on ETFs, we devote the remainder of this essay for an
econometric investigation of the relationship between local
Indian ETFs and their underlying indices.

using an error correction model. They find that except for the
ETFs from the real estate and banking and finance sectors, the
share price of all other ETFs and their underlying index prices
are cointegrated, indicating the absence of arbitrage opportunities and the prevalence of a long-run equilibrium. In addition, the tracking ability of ETFs were found to be positively
related to the trading volume and negatively related to the
daily volatility of ETF.

Since all the time series considered for this study were found
to be of the same order of integration, the EngleGranger cointegration test (Engle and Granger 1987) was employed using
the following framework.

4 Modelling Local Indian ETFs

We hereby consider five prominent ETFs floated by Benchmark

Asset Management (now part of Goldman Sachs Asset Management), namely, Goldman Sachs Nifty Exchange Traded
Scheme (NIFTYBEES), Goldman Sachs Nifty Junior Exchange
Table 3: A Snapshot of Different Time Series Considered for This Study
ETFs
Underlying Index
Time of Inception
Time Period Considered
Traded Scheme (JUNIORBEES), Goldman Sachs Banking Index
for This Study
Exchange Traded Scheme (BANKBEES), Goldman Sachs PSU Bank
NIFTYBEES
Nifty 50 Index
28 December 2001 1 August 2002 to
Exchange Traded Scheme (PSUBNKBEES), and Goldman Sachs
21 December 2012
Infrastructure Exchange Traded Scheme (INFRABEES).
JUNIORBEES Nifty Next 50 Index 21 February 2003 20 February 2004 to
Daily closing prices pertaining to the above-stated ETFs and
21 December 2012
the closing prices pertaining to their respective underlying
BANKBEES
Nifty Bank Index
27 May 2004
4 June 2004 to
21 December 2012
indices were downloaded from www.nseindia.com. Linear
PSUBNKBEES Nifty PSU Bank Index 25 October 2007
1 November 2007 to
interpolation was used to impute missing values. A snapshot of
21 December 2012
the different ETFs considered for this study, their respective
INFRABEES
Nifty Infrastructure 29 September 2010 5 October 2010 to
underlying indices and the ETF-wise time period considered
Index
21 December 2012
for this study is shown in Table 3.
Table 4: Summary Statistics of Different Time Series Considered for This Study
Further, the descriptive statistics
Indices
Number of Obs Mean
Maximum Minimum Standard
Skewness
Excess
Jarque
JB Sig
Deviation
Kurtosis
Bera (JB)
pertaining to logarithmic returns
Statistic
of ETFs and underling indices are
Logarithmic returns of ETF prices
made
available in Table 4.1
NIFTYBEES
2,858 0.0006 0.1365 -0.1259 0.0153 -0.3668 8.0326 7747.6833 0.0000
To start with, the augmented
JUNIORBEES
2,305 0.0005 0.1568 -0.1936 0.0205 -0.6180 13.6450 18028.4152 0.0000
DickeyFuller
(ADF), PhillipPerron
BANKBEES
2,229 0.0007 0.1797 -0.1466 0.0194 0.2291
7.1144 4720.2767 0.0000
PSUBANKBEES
1,341 0.0002 0.1398 -0.1267 0.0227 0.0007 4.7198 1244.6771 0.0000 (PP) tests and Kwiatkowski
INFRABEES
577 -0.0006 0.0898 -0.0750 0.0181
0.3415 2.3232
140.9747 0.0000 PhillipsSchmidtShin (KPSS) tests
Logarithmic returns of underlying index prices
were employed to ascertain the
Nifty 50
2,858 0.0006 0.1633 -0.1305 0.0155 -0.2666 10.0878 12152.2352 0.0000 order of integration of the differNifty Next 50
2,305 0.0005 0.1383 -0.1313 0.0178 -0.6838 8.0782 6447.0358 0.0000
ent time series considered for this
Nifty Bank Index
2,229 0.0007 0.1724 -0.1349 0.0204 0.0432 4.8398 2176.1746 0.0000
study. All ETFs and their underlyNifty PSU Bank Index
1,341 0.0002 0.1635 -0.1268 0.0223
0.1150 4.4527 1110.7882 0.0000
ing indices were found to be of
Nifty Infrastructure Index 577 -0.0007 0.0413 -0.0463 0.0136 -0.0186 0.5827
8.1971 0.0166
I(1) at levels/log-levels. Upon
In light of the fact that the public holding of domestic ETFs is first-differencing, all the time series were found to be I(0).
much greater than that of international ETFs in the US, Qadan These findings remained qualitatively the same, when ADF, PP
and Yagil (2012) investigated the price dynamics and tracking and KPSS tests were employed with a trend and a constant term.
ability of 42 local US ETFs and the impact of the recent 2008
09 financial crisis on the tracking ability of the local US ETFs 4.1 EngleGranger Test

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ETF = + UI +

...(1)

where ETFt and UIt are logarithmic closing prices of ETF and its
underlying index for day t.
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ISSUES IN FINANCIAL MARKETS

The estimated residuals from the above framework are then

investigated using the ADF unit root test shown below:

= + + e

...(2)

Should the t-statistics of the estimated parameters exceed

the critical value, then the estimated residuals are stationary.
In light of the non-stationarity of all the time series at levels/
logarithmic levels, prevalence of stationarity in the estimated
residuals from the above framework would indicate cointegration between ETFunderlying-indices pairs. As expected,
the ADF test outcomes, made available in Table 5, showed
prevalence of cointegrating relationships between each ETF
and its underlying index.
Table 5: ADF Test Findings Pertaining to EngleGranger Residuals
Model Specification

NIFTYBEES and Nifty 50

BANKBEES and Nifty Bank Index
JUNIORBEES and Nifty Next 50 Index
PSUBNKBEES and Nifty PSU Bank Index
INFRABEES and Nifty Infrastructure Index

ADF Test Statistic

without Trend

-7.2440***
-13.2035***
-5.1106***
-5.9051***
-12.2354***

ADF test Statistic

with Trend

-7.2403***
-13.2003***
-5.2284***
-6.8931***
-12.2915***

*** Critical values are -3.43, -2.86 and -2.57 for models without trend and -3.96, -3.41, and
-3.12 for models with trend at 1%, 5% and 10% significance levels.

4.2 GregoryHansen Test

The next technique that was employed was the Gregory

Hansen test. Gregory et al (1996) showed that the power of
Engle and Granger cointegration test drastically reduces in the
event of a structural break in the cointegration relationship. As
a result Gregory and Hansen (1996) proposed a new test
wherein the null hypothesis of no cointegration is tested
against the alternative hypothesis of cointegration with a
single structural break of unknown timing. The timing of the
structural break is determined endogenously. The following
three models were suggested by Gregory and Hansen (1996) to
test for a structural break.
Model 1: ETF = + + UI +

...(3)

Model 2: ETF = + + t + UI +

...(4)

Model 3: ETF = + + UI + UI + ...(5)

where 1, , 1, 2 are the coefficients, t is the error term, and
0 is the constant. Structural change is captured by the dummy
variable which is defined as follows.

1 if t >

0 if t
where is a relative timing of the change point.
As seen, model 1, otherwise called as shift model (C model),
allows for a break in intercept only, while model 2 allows for a
break in intercept and a trend term (otherwise called C/T
model). Model 3, which is otherwise called as a full-break
model (C/S model), allows for a break in the intercept and a
break in the slope of the cointegration vector. Models 1, 2 and 3
are estimated sequentially for each ETFunderlying-indices
pairs, and the estimated residuals are tested for stationarity
using ADF test. Setting the test statistic to the smallest value of
ADF statistic in the sequence, the value that constitutes the
strongest evidence against the null hypothesis of no cointegration
=

146

was selected. The findings based on GregoryHansen test

were qualitatively the same as those obtained from the Engle
Granger two-step cointegration tests.2
4.3 Error Correction Models or ECMs

As a complement to the GregoryHansen test, the BaiPerron

test that allows for a structural break in intercept and cointegrating vector was employed to estimate the break point along
with the unknown regression coefficients. BaiPerron test was
employed because it has been proved to be more efficient than
standard grid cointegration search procedures such as Gregory
Hansen (Bai and Perron 2003). Further, in order to investigate
the possibility of more than one structural break in the cointegrating relationship between each Indian ETF and its underlying index, the BaiPerron methodology (Bai and Perron 1998)
allowing for the two structural breaks each in the intercept
and the slope of the coefficient vector was then applied to
estimate the break points along with unknown regression
coefficients.
ETF = + DV1 + DV2 + UI + DV1 UI
+ DV2 UI +

...(6)

where 1, 2, 1, 2, 3 are the coefficients, t is the error term,

and 0 is the constant. Structural breaks are captured by the
dummy variables DV1 and DV2.
Residuals generated from the BaiPerron framework were
then employed in the following ECM, which is a stronger test
for cointegration than one based on residuals of a static cointegrating regression (Banerjee et al 1990; Kremers et al 1992).

ETF = UI + ETF + +

...(7)

where 1i, 2i, and are coefficients, and 0 is a constant, & t1

is the estimated residual based on BaiPerron methodology
that allows for two structural breaks in the cointegrating
vector. The parameter measures the speed of adjustment of
the model to disequilibriating shocks. This coefficient is
expected to be negative and significant. A larger negative value
of would indicate faster adjustment to long-run equilibrium.
Bayesian information criterion was used to arrive at the optimum number of lags for the ECM. The optimum number of lags
for logarithmic returns of NIFTYBEES, BANKBEES, JUNIORBEES,
PSUBNKBEES, and INFRABEES were found to be 6, 5, 11, 4 and 2
respectively. The estimated residuals from the error correction
Table 6: Modified LjungBox Test Outcomes Based on ECM Residuals
Model Specification

Number of Lag length

Observations for Modified
(T)
LjungBox
Test (2T )

NIFTYBEES
and Nifty 50
2,852
BANKBEES and
Nifty Bank Index
2,224
JUNIORBEES and
Nifty Next 50
2,294
PSUBNKBEES and
Nifty PSU Bank Index 1,337
INFRABEES and Nifty
Infrastructure Index
575
march 19, 2016

Degrees of Freedom
Modified Q
Correction
Statistic Significance
Initial
Final
Initial
Final
Iteration Iteration Iteration Iteration

106

14

16

0.0165

0.0429

94

12

14

0.0235

0.0240

95

24

24

0.2370

0.2370

73

10

20

0.0087

0.0477

47

0.0928

0.0928

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ISSUES IN FINANCIAL MARKETS

model were then tested for autoregressive conditional heteroscedasticity (ARCH) effects using Engles Lagrange multiplier (LM)
test (Engle 1982). LM test outcomes indicated the prevalence of
heteroscedasticity among estimated residuals pertaining to
each ECM. In light of heteroscedasticity, the estimated residuals
were then tested for autocorrelation using modified LjungBox
Test (West and Cho 1995).3 Table 6 (p 146) offers a snapshot of the
modified LjungBox test outcomes pertaining to ECM residuals.
Test outcomes pertaining to the initial iteration indicate no
autocorrelation among the ECM residuals pertaining to
JUNIORBEES, and high autocorrelation among residuals pertaining to PSUBANKBEES. Furthermore, the null hypothesis of
no autocorrelation holds at the 1% (although not at the 5%)
significance level for NIFTYBEES and BANKBEES and, at 5%
significance for INFRABEES.
Considering the relatively high level of autocorrelation
among the residuals pertaining to NIFTYBEES and PSUBANKBEES, the numbers of lags in the ECMs were increased on an
iterative basis and the ECMs were continuously re-estimated
with increasingly higher lags until the significance of the
modified Q statistic was found to be above 0.02.

GARCH (1,1) model was employed to model the error term.

ETF = UI + ETF + +

...(8)

= + +

...(9)
where is the conditional variance of the error term t.
The parametric estimates and their associated t-statistics
(shown in parentheses) pertaining to the different ECM
GARCH models for each of the five ETFs are shown in Table 7
(IGARCH refers to integrated GARCH).4,5,6,7,8
As expected, the error correction term in the mean model was
negative and significant for all ETFs, reiterating the prevalence of cointegration between each ETF and its underlying
index. In addition, the logarithmic returns of each ETF (ETFt)
at time t was found to be negatively impacted by its own lags
(ETFti), while lags of the logarithmic returns of the underlying index (UIti) were found to have a positive impact on
ETFt. Also, UIt was found to have an overwhelming impact
on ETFt in all cases.
A common theme that emerges from these ECMGARCH
estimations is the lack of goodness-of-fit of the mean model
(ECM) based on standardised residual diagnostics for all local
4.4 Modelling Conditional Volatility of ECMs
ETFs except for INFRABEES. Put simply, there is still considerable
In the light of the ARCH effects in ECM residuals pertaining to autocorrelation among the estimated standardised residuals,
each of the five ETFs, a parsimonious generalised ARCH or which indicates that the mean model is suboptimal, and that it
could potentially suffer from an omitted
Table 7: Parametric Estimates and t Statistics of Mean-variance Models for All ETFs
variable bias.
NIFTYBEES
BANKBEES
PSUBANKBEES
JUNIORBEES
INFRABEES

0
1
2
3
4
5
6
7
8
9
10
11
1
2
3
4
5
6
7
8
9
10
11
0
1
2
Shape

ECMIGARCH(1,1)1

ECMGARCH(1,1)2

ECMGARCH(1,1) T 3

ECM IGARCH(1,1)2

ECMGARCH(1,1)4

-0.094 (-6.426)
0.904 (161.834)
0.543 (23.479)
0.327 (12.919)
0.287 (11.279)
0.215 (8.719)
0.134 (5.698)
0.109 (4.956)
0.069 (3.676)

-0.236 (-10.105)
0.827 (97.780)
0.384 (14.186)
0.266 (9.764)
0.207 (7.768)
0.157 (5.994)
0.120 (4.854)
0.042 (2.039)

-0.145 (-4.980)
0.786 (64.512)
0.521 (14.274)
0.411 (10.837)
0.303 (8.204)
0.208 (5.501)
0.134 (3.709)
0.098 (2.823)
0.117 (3.722)
0.159 (5.709)
0.104 (4.305)

-0.564 (-8.241)
0.818 (31.412)
0.161 (2.485)
0.141 (2.864)

-0.562 (-23.205)
-0.35 (-13.263)
-0.289 (-10.866)
-0.211 (-8.250)
-0.130 (-5.310)
-0.108 (-4.748)
-0.071 (-3.673)

-0.393 (-14.128)
-0.280 (-9.892)
-0.209 (-7.543)
-0.159 (-5.852)
-0.102 (-4.036)
-0.037 (-1.823)

-0.501 (-13.185)
-0.389 (-10.003)
-0.308 (-8.180)
-0.186 (-4.780)
-0.153 (-4.176)
-0.114 (-3.313)
-0.121 (-3.814)
-0.152 (-5.513)
-0.085 (-3.838)

0.000 (0.000)
0.052 (9.321)
0.948 (169.567)

0.000 (2.855)
0.104 (5.814)
0.888 (46.713)

0.000 (2.938)
0.134 (5.779)
0.845 (34.003)
6.537 (6.484)

-0.183 (-5.389)
0.812 (65.772)
0.479 (12.848)
0.453 (11.728)
0.474 (12.230)
0.374 (9.850)
0.332 (8.699)
0.255 (6.935)
0.227 (6.271)
0.209 (6.287)
0.169 (5.440)
0.162 (5.791)
0.053 (2.514)
-0.540 (-14.440)
-0.474 (-12.409)
-0.455 (-11.648)
-0.387 (-10.137)
-0.294 (-7.744)
-0.272 (-7.455)
-0.268 (-7.533)
-0.204 (-6.180)
-0.156 (-5.110)
-0.114 (-4.227)
-0.066 (-3.429)
0.000 (0.000)
0.052 (12.642)
0.948 (230.262)

-0.165 (-2.703)
-0.078 (-1.917)

0.000 (1.678)
0.109 (3.503)
0.884 (25.951)

1: But for test statistics Q (17) to Q (27), Q statistic was found to be insignificant for lags ranging from 28 to 2T0.5. Q (17)
to Q (27) indicate rejection of null hypothesis at 5% level.
2: Q statistic was found to be significant for all lags up to 2T.0.5
3: Q statistic was found to be significant for all lags up to 2T0.5, but for Q (49), Q (50), Q (53) to Q (59), and Q (72).
4: Q statistic was found to be insignificant for all lags up to 2T.0.5
Economic & Political Weekly

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march 19, 2016

vol lI no 12

5 Conclusions

The central intent behind this paper is to

model the long-run relationship between
Indian ETFs and their respective UIs, and to
subsequently capture this long-run relationship between Indian ETFs and their underlying indices as part of our broader efforts to
model Indian ETFs per se.
Since ETFs are securities that theoretically
derive their value based on evolving prices of
underlying indices, modelling logarithmic
returns of Indian ETFs per se without capturing
the long-run relationship between Indian ETFs
and their respective underlying indices would
be uninformed and superfluous in nature.
As a result, we employ the EngleGranger,
GregoryHansen, and BaiPerron tests to
capture the long-run relationship between
Indian ETFs and their respective underlying
indices. As expected, the different test outcomes pertaining to this preliminary modelling phase indicated prevalence of cointegrating relationship between ETFs and their underlying indices. However, subsequent efforts
undertaken by us to capture this cointegrating
relationship using ECMs as part of our broader
efforts to model Indian ETFs, uncovered
unexpected empirical realities.
147

ISSUES IN FINANCIAL MARKETS

Notwithstanding the success of ECM models in capturing

long-run relationship between ETFs and underlying indices, the
residuals derived from such models exhibited autocorrelation,
ARCH effects, and asymmetry effects. Econometric efforts
aimed at overcoming such residual autocorrelation effects,
residual ARCH effects, and asymmetry effects paved the way to
ECMGARCH models of different orders and different underlying distributions for each of the ETFs considered for this study. A
common theme that emerged from our ECMGARCH models is
Notes
1

2
3

In the interest of brevity, the line plots and

descriptive statistics pertaining to the time
series in levels are not presented here.
In the interest of brevity, GregoryHansen and
BaiPerron test outcomes are not reported here.
Modified Q statistic were generated at a lag of
2 where T indicates the number of observations
of time series considered in the ECM.
In the case of NIFTYBEES, (1+2) was found to
be greater than one. Consequently, an IGARCH
model without variance drift was employed to
model the conditional volatility of the error
term. The standardised residuals of ECM
IGARCH were then tested for residual ARCH
effects using Engles LM test. Test results indicated absence of residual ARCH effects. Then
LjungBox test (Q) outcomes for all lags up to
2 lag length were estimated so as to ascertain
the goodness-of-fit of the mean model based on
standardised residuals of ECMIGARCH(1,1)
model. But for Q(17) to Q(27), the null hypothesis of no autocorrelation persists for lags ranging from 28 to 2 . However, Q statistics for
lags ranging from 17 to 27 indicate rejection of
null hypothesis at 5% significance level.
In the case of BANKBEES, no residual ARCH
effects were found among the standardised
residuals of the ECMGARCH(1,1) model. However, the LjungBox test revealed the prevalence of autocorrelations among the standardised residuals for all lags up to 2 . This implies
that the mean model is inferior and warrants
improvement. Consequently, the ECMGARCH(1,1) model was re-estimated using the t-distribution and the generalised error distribution,
but they yielded no improvements when compared to the ECMGARCH(1,1) model with the
normal distribution.
In the case of PSUBANKBEES, residual ARCH
effects were found among the standardised
residuals of the ECMGARCH(1,1) model. Furthermore, the LjungBox test outcomes indicated
the prevalence of autocorrelations among
standardised residuals at the 5% significance
(although not at the 1% significance). This implies
that both the mean and the variance model were
suboptimal. Consequently, the ECMGARCH(1,1)
model was re-estimated by employing a t-distribution, as opposed to the normal distribution. Subsequently, the estimated standardised residuals were tested for autocorrelation
and residual ARCH effects. The LjungBox
statistic improved marginally subsequent to
the re-estimation using the t-distribution,
whereby the null hypothesis of no autocorrelation among the standardised residuals failed
to get rejected at the 5% significance level as
indicated by Q statistics at certain specific lag
lengths such as and limited to Q(49), Q(50),
Q(53) to Q(59), and Q(72). However, Q statistics for all other lags up to 2 indicate rejection of null hypothesis at the 5% significance
level, which in turn implies a lack of goodnessof-fit of the mean model. Further, LM test
results indicated absence of residual ARCH
effects among the standardised residuals.

148

the lack of goodness-of-fit of the mean model for all local ETFs
considered for this study, except for INFRABEES. These findings
indicate that long-run relationship between Indian ETFs and
their respective underlying indices fails to fully explain the
price dynamics of Indian ETFs per se. In other words, Indian
ETFs serve as an imperfect hedge for investors who have exposure to the respective underlying indices, for the empirical relationship between ETFs and underlying indices do not exactly
mimic the theoretical antecedents of derivative securities.9

In the case of JUNIORBEES, the sum of the

ARCH and GARCH coefficients (1+2) were
found to be greater than one. Consequently, an
IGARCH model without variance drift was
employed to model the conditional volatility of
the error term. The standardised residuals from
the ECMIGARCH(1,1) model were then tested
for residual ARCH effects using Engles LM test.
Test results indicated absence of residual ARCH
effects. Furthermore, the LjungBox test outcomes
indicated a rejection of the null hypothesis of no
autocorrelation among standardised residuals at
the 5% significance level (although not at the 1%
significance level). This implies that the mean
model is suboptimal and warrants improvement.
In the case of INFRABEES, no residual ARCH
effects were found among the standardised
residuals of the ECMGARCH(1,1) model. Furthermore, the LjungBox test failed to reject
the null hypothesis of no autocorrelation among
the standardised residuals at the 5% significance
level. The standardised residuals of the ECM
GARCH models pertaining to each ETF were also
subjected to Engle and Ngs (1993) diagnostic
tests, namely, the sign bias, negative size bias,
positive size bias, and joint test, to test for asymmetry in conditional volatility. Engle and Ng test
outcomes indicated no asymmetry effect in any
of the ETFs except for JUNIORBEES. In the case
of JUNIORBEES, an ECMGJRGARCH(1,1) model
was employed to model asymmetry effect. However, this exercise yielded no improvements when
compared to original ECMIGARCH(1,1) model.
In the interest of brevity, the Engle and Ng test
outcomes are not shown here.
We also undertook efforts to model Indian ETFs
by using the univariate ARGARCH approach.
Residual diagnostics of such univariate AR
GARCH models indicated far-superior mean
models in comparison to ECMGARCH models
that capture the long-run relationship between
ETFs and their respective underlying indices. We
believe that these findings reflect a seeminglydetached attachment between Indian ETFs and
their respective underlying indices. In the interest of brevity, the ARGARCH estimations and
their residual diagnostics are not reported here.

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