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Financial Innovation, Investor Behavior, and Arbitrage: Implications from the ETF Market

26 Pages Posted: 16 Mar 2012 Last revised: 1 Apr 2016

Wenxi Jiang

CUHK Business School, The Chinese University of Hong Kong

Hongjun Yan

Driehaus College of Business, DePaul University

Date Written: March 31, 2016

Abstract

Regular and levered ETFs are markedly different financial innovations. Regular ETFs improve liquidity: they are more liquid than their underlying stocks. In contrast, although the levered ETF market has a substantially higher turnover, it also has a significantly higher bid-ask spreads and larger price impacts. Our interpretation is that levered ETFs are appealing to short-term levered speculators. The aggregate cost levered ETF investors incur is around 10% of the market capitalization, or around $2 billion, each year. Moreover, regular ETF investors appear to be momentum traders, while levered ETF investors are contrarians: For regular (levered) ETFs, their monthly fund flows are strongly positively (negatively) correlated with past returns. Finally, arbitrage forces push ETF prices partially towards their NAVs, and this mechanism is less effective for levered ETFs than for regular ones.

Keywords: Financial Innovation, Leverage, Investor behavior, Index

JEL Classification: G11, G23

Suggested Citation

Jiang, Wenxi and Yan, Hongjun, Financial Innovation, Investor Behavior, and Arbitrage: Implications from the ETF Market (March 31, 2016). Available at SSRN: https://ssrn.com/abstract=2023142 or http://dx.doi.org/10.2139/ssrn.2023142

Wenxi Jiang

CUHK Business School, The Chinese University of Hong Kong ( email )

Room 1250, Cheng Yu Tung Building
Chinese University of Hong Kong
Shatin, NT 06520
Hong Kong

Hongjun Yan (Contact Author)

Driehaus College of Business, DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/site/hongjunyanhomepage/

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