39 Pages Posted: 21 Nov 2016 Last revised: 17 Jul 2017
Date Written: November 18, 2016
Many finance models assume the existence of noise traders who push asset prices away from fundamental values. Yet empirically, these "animal spirits" are challenging to observe because fundamental values are inherently unobservable. We examine a novel database of trades by ETF authorized participants who specifically trade to correct violations of the law of one price. These trades allow us to measure arbitrage activity. We show that noise traders do not cancel each other out and arbitrage activity is associated with predictable price distortions. Our analysis indicates that noise traders exert a non-fundamental impact on market outcomes even when arbitrageurs are active. Thus, noise traders are not simply noise, they impact prices.
Keywords: Exchange Traded Funds, ETFs, Law of One Price, Return Predictability, Arithmetic of Active Management
JEL Classification: G12, G14
Suggested Citation: Suggested Citation
Brown, David C. and Davies, Shaun William and Ringgenberg, Matthew, ETF Arbitrage and Return Predictability (November 18, 2016). Available at SSRN: https://ssrn.com/abstract=2872414
By Meb Faber