Exchange-Traded Funds and Equity Return Correlations

Abstract:     
We provide novel evidence that arbitrageurs can exacerbate return comovement via ETF arbitrage. Using a large sample of U.S. equity ETF holdings, we find a strong relation between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects. The effect is stronger among small and illiquid stocks and during market turbulence. An examination of delay measures and sentiment betas suggests that at least some ETF-driven return comovement is excessive. In other words, ETFs may reduce diversification, the very benefit they were designed to facilitate.

Number of Pages in PDF File: 52

Keywords: exchange-traded funds, correlation

JEL Classification: G14, G23

working papers series