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ETF Arbitrage and Return Predictability

39 Pages Posted: 21 Nov 2016 Last revised: 17 Jul 2017

David C. Brown

University of Arizona - Department of Finance

Shaun William Davies

University of Colorado at Boulder - Leeds School of Business

Matthew Ringgenberg

University of Utah - Department of Finance

Date Written: November 18, 2016

Abstract

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

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

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 William 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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