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ETF Arbitrage, Non-Fundamental Demand, and Return Predictability
[The equity share in new issues and aggregate stock returns]

Author

Listed:
  • David C Brown
  • Shaun William Davies
  • Matthew C Ringgenberg

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 that is short high-flow ETFs and long low-flow ETFs earns excess returns of 1.1–2.0% 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.

Suggested Citation

  • David C Brown & Shaun William Davies & Matthew C Ringgenberg, 2021. "ETF Arbitrage, Non-Fundamental Demand, and Return Predictability [The equity share in new issues and aggregate stock returns]," Review of Finance, European Finance Association, vol. 25(4), pages 937-972.
    • Handle: RePEc:oup:revfin:v:25:y:2021:i:4:p:937-972.
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    File URL: http://hdl.handle.net/10.1093/rof/rfaa027
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    Citations

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    Cited by:

    1. Xu, Liao & Pu, Wenyan, 2022. "ETFs, arbitrage activity, and stock market efficiency: Evidence from Chinese CSI 300 ETFs," Economic Analysis and Policy, Elsevier, vol. 73(C), pages 1-9.
    2. Padma Kadiyala, 2022. "Response of ETF flows and long-run returns to investor sentiment," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 36(4), pages 489-531, December.
    3. Liu, Sha, 2023. "Do investors and managers of active ETFs react to social media activities?," Finance Research Letters, Elsevier, vol. 51(C).
    4. Dumitrescu, Ariadna & Järvinen, Jesse & Zakriya, Mohammed, 2023. "Hidden Gem or Fool’s Gold: Can passive ESG ETFs outperform the benchmarks?," International Review of Financial Analysis, Elsevier, vol. 86(C).
    5. Duffy, John & Friedman, Dan & Rabanal, Jean Paul & Rud, Olga, 2022. "The impact of ETF index inclusion on stock prices," UiS Working Papers in Economics and Finance 2022/2, University of Stavanger.
    6. Gemayel, Roland & Franus, Tatiana & Bowden, James, 2023. "Price discovery between Bitcoin spot markets and exchange traded products," Economics Letters, Elsevier, vol. 228(C).
    7. Bohl, Martin T. & Irwin, Scott H. & Pütz, Alexander & Sulewski, Christoph, 2023. "The impact of financialization on the efficiency of commodity futures markets," Journal of Commodity Markets, Elsevier, vol. 31(C).
    8. Chen, Jilong & Xu, Liao, 2023. "Do exchange-traded fund activities destabilize the stock market? Evidence from the China securities index 300 stocks," Economic Modelling, Elsevier, vol. 127(C).
    9. Syed Riaz Mahmood Ali, 2022. "Herding in different states and terms: evidence from the cryptocurrency market," Journal of Asset Management, Palgrave Macmillan, vol. 23(4), pages 322-336, July.
    10. El Kalak, Izidin & Leung, Woon Sau & Takahashi, Hidenori & Yamada, Kazuo, 2023. "The Bank of Japan's equity purchases and stock illiquidity," Journal of Financial Markets, Elsevier, vol. 63(C).
    11. Lyons, Richard K. & Viswanath-Natraj, Ganesh, 2023. "What keeps stablecoins stable?," Journal of International Money and Finance, Elsevier, vol. 131(C).

    More about this item

    Keywords

    Exchange-traded funds (ETFs); ETF flows; Non-fundamental demand; return predictability;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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