1 THE EXCHANGE TRADED FUNDS’ PRICING DEVIATION: ANALYSIS AND FORECASTS Richard A. DeFusco Associate Professor University of Nebraska - Lincoln Stoyu I. Ivanov ∗ Doctoral Student University of Nebraska - Lincoln Gordon V. Karels Nebraska Bankers Association College Professor of Banking University of Nebraska - Lincoln Version: September 27, 2007 Abstract: In this paper, we study the price deviations of the three most liquid Exchange Traded Funds (ETFs): the Spiders (S&P500 tracking ETF); the Diamonds (Dow Jones Industrial Average tracking ETF); and the Cubes (NASDAQ 100 tracking ETF). The price deviation is stationary and predictable, and therefore can be considered an additional, implicit transaction cost (in addition to the bid-ask spread, and the explicit transaction costs, such as brokerage and maintenance fees). The reason for the predictability of the pricing deviation stems from its stationarity, clustering of volatility, specific price discovery processes, lead-lag relationships and dividend accumulation and distribution for this asset class. We conduct a comprehensive study of ETF pricing deviation and provide new perspectives for the performance evaluation literature which is using a static benchmark. The current state of computational technology allows for more precise computations when benchmarks for performance such as accounting for different costs associated with the selection of a benchmark are used. Keywords: Exchange Traded Funds, Pricing Deviation JEL classification: G10, G14 The paper was previously circulated under the title “The Exchange Traded Funds’ Tracking Error: Analysis and Forecasts”. We wish to thank John Geppert, James Schmidt, Tom Nohel and seminar participants at the 2007 Midwest Finance Association meeting for insightful comments. Any errors are our own. ∗ Corresponding Author: University of Nebraska-Lincoln Department of Finance Lincoln, NE 68588-0490 Phone: (402) 472-3445 Email: ivanovsi@bigred.unl.edu