ETF Arbitrage, Non-Fundamental Demand, and Return Predictability

56 Pages Posted: 21 Nov 2016 Last revised: 17 Apr 2020

See all articles by David C. Brown

David C. Brown

University of Arizona - Department of Finance

Shaun Davies

University of Colorado at Boulder - Leeds School of Business

Matthew Ringgenberg

University of Utah - Department of Finance

Date Written: April 17, 2020

Abstract

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

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

David C. Brown

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States
520-626-0746 (Phone)

HOME PAGE: http://www.davidclaytonbrown.com

Shaun Davies (Contact Author)

University of Colorado at Boulder - Leeds School of Business ( email )

Boulder, CO 80309-0419
United States

Matthew C. Ringgenberg

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States

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