Intraday Arbitrage Between ETFs and their Underlying Portfolios
73 Pages Posted: 30 Jan 2019
Date Written: January 25, 2019
Current research suggests that arbitrage activity in exchange traded funds (ETFs) impacts the market quality of their constituent securities. We examine this proposition directly by identifying intraday arbitrage opportunities between 423 domestic equity ETFs and their underlying portfolios. Ultimately, we find little evidence that mispricing events alter the direction of constituent order flow. Furthermore, we observe that arbitrage opportunities are usually preceded by a price shock and order imbalance in the underlying portfolio. Even though prices for the ETF and constituent securities converge quickly, parity is restored through adjustments in the best bid and offer quotes, not arbitrage trading. Moreover, the direction of order flow following a mispricing event is more consistent with liquidity provider hedging, whereby aggressive price quotes for the ETF might serve to offset liquidity provision in the underlying securities.
Keywords: Exchange traded funds (ETFs), limits to arbitrage, liquidity
JEL Classification: G12, G14
Suggested Citation: Suggested Citation