ETF Sampling and Index Arbitrage

56 Pages Posted: 14 Jan 2020 Last revised: 16 Aug 2023

See all articles by Jonathan Brogaard

Jonathan Brogaard

University of Utah - David Eccles School of Business

Davidson Heath

University of Utah - David Eccles School of Business

Da Huang

Northeastern University - D'Amore-McKim School of Business

Date Written: Aug 15, 2023

Abstract

This paper shows that exchange-traded funds (ETFs) "sample" their indexes, systematically underweighting or omitting illiquid index stocks. As a result, arbitrage activity between the ETF and its index has heterogeneous effects on underlying asset markets. Using an instrumental variables approach, we find that the trading activity of ETFs reduces liquidity and price efficiency and increases volatility and co-movement for liquid stocks, but has no effect on illiquid stocks. Our results demonstrate that the effects of passive investing on asset markets depend on how passive funds replicate their target index.

Keywords: exchange-traded funds, passive investment, index, replication strategy, market quality

JEL Classification: G11, G12, G20

Suggested Citation

Brogaard, Jonathan and Heath, Davidson and Huang, Da, ETF Sampling and Index Arbitrage (Aug 15, 2023). Available at SSRN: https://ssrn.com/abstract=3510359 or http://dx.doi.org/10.2139/ssrn.3510359

Jonathan Brogaard

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

HOME PAGE: http://www.jonathanbrogaard.com

Davidson Heath (Contact Author)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

Da Huang

Northeastern University - D'Amore-McKim School of Business ( email )

Northeastern University
413B Hayden
Boston, MA 02215
United States

HOME PAGE: http://dahuang-finance.github.io

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