ETF Arbitrage, Non-Fundamental Demand, and Return Predictability

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

Brown, David C. and Davies, Shaun and Ringgenberg, Matthew C., ETF Arbitrage, Non-Fundamental Demand, and Return Predictability (April 17, 2020). Available at SSRN: https://ssrn.com/abstract=2872414 or http://dx.doi.org/10.2139/ssrn.2872414