67 Pages Posted: 12 Dec 2018 Last revised: 16 May 2022
Date Written: May 29, 2020
I argue that arbitrage mistranslates factor information from ETFs to constituent securities and distorts comovement. The intuition behind this distortion is arbitrageurs trade constituent securities not based on their fundamental exposures but by their portfolio weights, causing securities to comove with the ETF based on a measure I call arbitrage sensitivity — a combination of portfolio weight and price impact sensitivity — rather than fundamental exposures. Arbitrage sensitivity predicts comovement between stock and ETF returns, especially in periods of high ETF volume and volatility, but not before 2008 when ETFs were not as heavily traded. Arbitrage-induced comovement leads to over-reaction to ETF returns for stocks more sensitive to arbitrage and under-reaction for those less sensitive. A long-short portfolio constructed based on arbitrage sensitivity generates an alpha of around 7.5% per year. Unlike most anomalies, arbitrage comovement is strongest in large-cap stocks, which are held by the most actively traded ETFs. Arbitrage comovement implies observed factor loadings are less reliable for assessing risk since they are at least partially driven by mechanical arbitrage trading instead of fundamental exposures.
Keywords: Comovement, Empirical Asset Pricing, Arbitrage, ETFs, Algorithmic Trading
JEL Classification: G12, G14, G10, G20
Suggested Citation: Suggested Citation