Regime Switching in High-Tech ETFs: Idiosyncratic Volatility and Return

Abstract

The volatility of asset returns can be classified into market and firm-specific volatility, otherwise known as idiosyncratic volatility. Idiosyncratic volatility is increasing over time with some literature attributing this to the IT revolution. An understanding of the relationship between idiosyncratic risk and return is indeed relevant for idiosyncratic risk pricing and asset allocation, in a context of emerging technologies. The case of high-tech exchange traded funds (ETFs) is especially interesting, since ETFs introduce new noise to the market due to arbitrage activities and high frequency trading. This article examines the relevance of idiosyncratic risk in explaining the return of nine high-tech ETFs. The Markov regime-switching (MRS) methodology for heteroscedastic regimes has been applied. We found that high-tech ETF returns are negatively related to idiosyncratic risk during the high volatility regime and positively related to idiosyncratic risk during the low volatility regime. These results suggest that idiosyncratic volatility matters in high-tech ETF pricing, and that the effects are driven by volatility regimes, leading to changes across them.