Does Spurious Mean Reversion in Basis Changes Still Exist After the Introduction Exchange Traded Funds?

Abstract

In their seminal Journal of Finance article, Miller, Muthuswamy, and Whaley (MMW, 1994) document that the observed mean reversion of changes in the basis of cash and stock index futures prices is likely illusory. MMW use a simple time-series model to suggest that the apparent mean-reversion in the basis is a spurious artefact of nonsynchronous prices between index futures and cash markets - rather than an indication of exploitable weak-form market inefficiency. Because the MMW effect is predominantly driven by liquidity differentials between cash and futures prices, the question naturally arises as to whether one would observe the same MMW phenomenon in the behavior of the basis or difference between more actively traded exchange traded funds (ETF) and cash market prices. This study attempts to answer that question by examining the basis behavior of the Standard and Poor’s Depository Receipt (SPDR) ETF traded on the American Stock Exchange. Overall, we find that the MMW phenomenon still persists strongly after the advent of exchange traded funds. Moreover, an examination of the spread or basis between cash and ETF prices and the spread or basis between futures and ETF prices shows that the apparent mean reversion in both is even more pronounced than in the basis between cash and futures prices. This demonstrates that the MMW effect is extremely robust and unlikely to go away soon.