ETF Arbitrage, Non-Fundamental Demand, and Return Predictability*

Abstract

Non-fundamental demand shocks have significant effects on asset prices, but observing these shocks is challenging. We use the exchange traded fund (ETF) primary market to study non-fundamental demand. Unique to the ETF market, specialized arbitrageurs called authorized participants correct violations of the law of one price between an ETF and its underlying assets by creating or redeeming ETF shares. We show theoretically and empirically that creation and redemption activities (ETF flows) provide signals of non-fundamental demand shocks. A portfolio which is short high-flow ETFs and long low-flow ETFs earns excess returns of 1.1% to 2.0% per month, consistent with non-fundamental demand distorting asset prices away from fundamental values. Moreover, we show non-fundamental demand imposes non-trivial costs on investors, leading to underperformance.

Naïve Style-Level Feedback Trading in Passive Funds

“…The correlation is even weaker between fund-level flows and relative (own-distant) style flows (0.13). These results complement the fund-level return predictability documented by Brown et al (2021) for a broader sample of ETFs.…”

“…) is aggregated over the specified time period t (e.g., a month). 3 Net flows signal relative nonfundamental demand for the ETF compared with its underlying portfolio 4 that generated a profitable arbitrage opportunity (Brown, Davies, and Ringgenberg (2021)). For example, suppose that noise-trader demand for a financial sector ETF in the secondary market pushes the ETF price above the NAV price.…”

“…These features make ETFs more attractive to style-momentum traders compared with their underlying securities. Net flows, reflecting relative nonfundamental demand for an ETF vis-à-vis its underlying securities (Brown et al (2021)), should therefore be positively related to past style-level returns.…”

“…There are two possible interpretations of these negative coefficients. First, as shown by Brown et al (2021), net flows reflect relative nonfundamental demand for the ETF compared with its underlying securities. Consequently, the negative flow-performance relationship over intermediate horizons may signal that ETF investors continue to trade on style momentum but not as strongly as the investors in the underlying stocks do.…”

Short-Selling Equity Exchange Traded Funds and Its Effect on Stock Market Liquidity

“…An important role of the ETF creation mechanism is to ensure that an ETF trades close to its NAV. If the total cost of the underlying basket of assets, the ETF's NAV, is less than the price of the ETF (i.e., the ETF is trading at a premium), an arbitrageur can purchase the underlying assets, deliver the basket of constituent securities to the AP, and sell the newly created ETF (Brown, Davies, and Ringgenberg (2021) provide a detailed description of this mechanism). To evaluate the potential effect of the NAV-arbitrage channel, we begin by visually examining SPY's premium alongside SPY's shares outstanding (Graph C of Figure 3).…”