Arbitrage Comovement

76 Pages Posted: 12 Dec 2018 Last revised: 13 Apr 2019

See all articles by John J. Shim

John J. Shim

University of Chicago, Booth School of Business, Students

Date Written: March 12, 2019

Abstract

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 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 arbitrage trading instead of fundamental exposures.

Keywords: Comovement, Empirical Asset Pricing, Arbitrage, ETFs, Algorithmic Trading

JEL Classification: G12, G14, G10, G20

Suggested Citation

Shim, John J., Arbitrage Comovement (March 12, 2019). Available at SSRN: https://ssrn.com/abstract=3287912 or http://dx.doi.org/10.2139/ssrn.3287912

John J. Shim (Contact Author)

University of Chicago, Booth School of Business, Students ( email )

Chicago, IL
United States

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