Mind Thy Neighbor's Portfolio: A Network Approach to Contagion in the ETF Market

Abstract

The exchange-traded fund (ETF) market has become the most important recent development in financial markets. I show that the ETF network-the linkages between ETFs based on portfolio weights-catalyzes the propagation of price dislocations, the gaps between prices and fundamental values. Arbitrage activity induces price dislocations in connected ETFs, followed by responses in returns and subsequent reversals with an effect of 3-7% per year. While own fund flows create price pressure, bundled flows from neighboring funds can exert stronger price pressure in the opposite direction. This channel partially explains how price dislocations naturally arise in the ETF market.

Keywords: Contagion, ETF, network, return predictability, authorized participant, federal reserve

JEL Classification: G12, G14, G23