ETF Flows and Underlying Stock Returns: The True Cost of NAV-Based Trading

Abstract

In this paper, we examine whether the creation or redemption ETF shares has a measurable and significant effect on the underlying stocks’ returns in the closing auction. Our findings show that ETF flow-related stock transactions significantly affect stock prices. We provide empirical evidence showing that creations/redemptions of ETFs that replicate indices in the German DAX index family have a highly significant and economically viable effect on abnormal returns of underlying stocks in the closing auction an effect that is particularly pronounced in small stocks and on bullish trading days. We argue that, given the sizable additional annual earnings of up to € 53,000 per stock, the AP has a motivation to exploit this inefficiency, by means of active price manipulation during the closing auction. Hence, dealing in ETF shares on the primary market, for example through NAV-based orders, might entail hidden costs for investors that, until now, have not been recognised in the literature and perhaps not even by investment professionals.

Keywords: ETF, Exchange-traded fund, Fund flows, Trading volume, Asset basket, Asset pricing

JEL Classification: G12, G14, G15, G23