ETF Arbitrage, Non-Fundamental Demand, and Return Predictability
56 Pages Posted: 21 Nov 2016 Last revised: 17 Apr 2020
Date Written: April 17, 2020
Non-fundamental demand shocks have significant effects on asset prices, but observing these shocks is challenging. We use the exchange traded fund (ETF) primary market to study non-fundamental demand. Unique to the ETF market, specialized arbitrageurs called authorized participants correct violations of the law of one price between an ETF and its underlying assets by creating or redeeming ETF shares. We show theoretically and empirically that creation and redemption activity (ETF flows) provides signals of non-fundamental demand shocks. A portfolio which is short high flow ETFs and long low flow ETFs earns excess returns of 1% to 4% per month, consistent with non-fundamental demand distorting asset prices away from fundamental values. Moreover, non-fundamental demand imposes non-trivial costs on ETF investors, leading to underperformance.
Keywords: Exchange Traded Funds (ETFs), ETF Flows, Non-Fundamental Demand, Return Predictability
JEL Classification: G12, G14
Suggested Citation: Suggested Citation