Diversification and idiosyncratic volatility puzzle: Evidence from ETFs

Exchange Traded Funds (ETFs) are considered diversified portfolios with low transaction costs and high liquidity. We test the impact of idiosyncratic risk on the cross-sectional returns of ETFs. We find the magnitude of idiosyncratic risk for U.S. equity ETFs is less than half of that of the sector equity ETFs. We show evidence that the idiosyncratic volatility (IVOL) puzzle only exists for sector equity ETFs, albeit they have a significant number of constituents. These findings are robust to ETF price, size, liquidity, different idiosyncratic risk estimates, and the subset of ETFs with a large number of constituents.