ETF Arbitrage and Return Predictability

58 Pages Posted: 21 Nov 2016 Last revised: 22 Jan 2018

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: January 22, 2018

Abstract

Demand shocks generate mispricing between identical securities leading to arbitrage activity that restores relative price efficiency. However, relative price efficiency does not imply absolute price efficiency as either demand shocks or subsequent trades by arbitrageurs may push assets prices away from latent fundamental values. In theory, if arbitrage trades are observable, such distortions are short-lived. Exchange traded funds (ETFs) provide a novel setting in which arbitrage trades are publicly observable shortly after they occur. We find that arbitrage activity negatively predicts subsequent returns, indicating that market participants fail to incorporate this observable information into prices.

Keywords: Arbitrage, Weak-Form Market Efficiency, Return Predictability, Exchange Traded Funds (ETFs), Demand Shocks

JEL Classification: G12, G14

Suggested Citation

Brown, David C. and Davies, Shaun and Ringgenberg, Matthew, ETF Arbitrage and Return Predictability (January 22, 2018). 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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