The Returns and Limits to Relative-Value ETF Arbitrage

Abstract

This paper studies relative price gaps between pairs of nearly identical Exchange-Traded Funds (ETFs) listed on US exchanges. Prices usually move in lockstep, but sometimes diverge from parity by larger amounts. Over the period 2010-2016, a simple pairs trading strategy produced abnormal returns of up to 1.8 percent per year net of fees. Price gaps cannot be justified by fundamental differences in liquidity, replication methodologies, or security lending activities, but are related to both proxies for cross-sectional and time-varying limits to arbitrage. Prices typically diverge following a sequence of days with abnormally low liquidity in both the relatively over- and underpriced fund.

Keywords: law of one price, arbitrage, limits to arbitrage, market efficiency, Exchange-Traded-Funds, ETFs, pairs trading

JEL Classification: G02, G12, G14