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ETF Arbitrage and Return Predictability
David C. BrownUniversity of Arizona
Shaun William DaviesUniversity of Colorado Boulder
Matthew RinggenbergUniversity of Utah
January 5, 2018
American Finance Association Annual Meeting
1 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Demand Shocks and Absolute Price Efficiency
Demand shocks hit assets and move prices
Informed traders (Kyle 1985)
Noise traders (Shleifer and Summers 1990)
Sources of demand shocks are often unknown for long periods of time,leading to predictable returns
Fire sales (Coval and Stafford 2007)
Mutual fund flows (Lou 2012)
Thus, demand shocks often result in absolute price inefficiency
2 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Demand Shocks and Absolute Price Efficiency
Demand shocks hit assets and move prices
Informed traders (Kyle 1985)
Noise traders (Shleifer and Summers 1990)
Sources of demand shocks are often unknown for long periods of time,leading to predictable returns
Fire sales (Coval and Stafford 2007)
Mutual fund flows (Lou 2012)
Thus, demand shocks often result in absolute price inefficiency
2 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Demand Shocks and Absolute Price Efficiency
Demand shocks hit assets and move prices
Informed traders (Kyle 1985)
Noise traders (Shleifer and Summers 1990)
Sources of demand shocks are often unknown for long periods of time,leading to predictable returns
Fire sales (Coval and Stafford 2007)
Mutual fund flows (Lou 2012)
Thus, demand shocks often result in absolute price inefficiency
2 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Relative Price Efficiency and ETFs
When identical assets exist, arbitrageurs ensure the law of one price holds
For example, ETFs and their underlying securities (NAV)
Authorized participants make arbitrage trades to maintain relative priceefficiency (Petajisto 2017, Engle and Sarkar 2006)
Relative price efficiency does not imply absolute price efficiency
3 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Relative Price Efficiency and ETFs
When identical assets exist, arbitrageurs ensure the law of one price holds
For example, ETFs and their underlying securities (NAV)
Authorized participants make arbitrage trades to maintain relative priceefficiency (Petajisto 2017, Engle and Sarkar 2006)
Relative price efficiency does not imply absolute price efficiency
3 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Relative Price Efficiency and ETFs
When identical assets exist, arbitrageurs ensure the law of one price holds
For example, ETFs and their underlying securities (NAV)
Authorized participants make arbitrage trades to maintain relative priceefficiency (Petajisto 2017, Engle and Sarkar 2006)
Relative price efficiency does not imply absolute price efficiency
3 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Relative Price Efficiency and ETFs
When identical assets exist, arbitrageurs ensure the law of one price holds
For example, ETFs and their underlying securities (NAV)
Authorized participants make arbitrage trades to maintain relative priceefficiency (Petajisto 2017, Engle and Sarkar 2006)
Relative price efficiency does not imply absolute price efficiency
3 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Non-Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Non-Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Non-Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ArbitrageActivity
NAV2
ETF2
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Non-Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ArbitrageActivity
Return ToFundamentalValue
NAV2
ETF2
NAV3
ETF3
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ArbitrageActivity
NAV2
ETF2
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
ETF Arbitrage Example
NAV0
ETF0
Fundamental Demand Shocks and Arbitrage TradesETF Share Price and Underlying NAV
t=0 t=1 t=2 t=3
NAV1
ETF1
RelativeDemandShocks
ArbitrageActivity
Return ToFundamentalValue
NAV2
ETF2
NAV3
ETF3
ETFPremium
4 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks
2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
Null Hypothesis: Weak-Form Market Efficiency
Relative demand shocks lead to arbitrage activity
Following arbitrage activity, prices should return to fundamental values
Non-fundamental shocks → price reversions
Fundamental shocks → price continuation
Arbitrage activity is:
1 symptomatic of relative demand shocks2 observable
Absolute price efficiency should be quickly restored
Null hypothesis: Monthly arbitrage activity does not predict monthly returns
5 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
What We DoOverview
Use ETF creation / redemption mechanism to test whethermarkets incorporate the information in arbitrage trades
ETFs provide a unique opportunity to identify demand shocksAuthorized Participants engage in arbitrage trades to correct mispricing fromrelative demand shocksDaily share changes provide an observable measure of arbitrage activity
Preview of Results
Arbitrage activity predicts future asset returnsFor both the underlying stocks and ETFs themselves
Arbitrage activity is associated with return reversals
ETF investors collectively mistime the market
6 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
What We DoOverview
Use ETF creation / redemption mechanism to test whethermarkets incorporate the information in arbitrage trades
ETFs provide a unique opportunity to identify demand shocksAuthorized Participants engage in arbitrage trades to correct mispricing fromrelative demand shocksDaily share changes provide an observable measure of arbitrage activity
Preview of Results
Arbitrage activity predicts future asset returnsFor both the underlying stocks and ETFs themselves
Arbitrage activity is associated with return reversals
ETF investors collectively mistime the market
6 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
What We DoOverview
Use ETF creation / redemption mechanism to test whethermarkets incorporate the information in arbitrage trades
ETFs provide a unique opportunity to identify demand shocksAuthorized Participants engage in arbitrage trades to correct mispricing fromrelative demand shocksDaily share changes provide an observable measure of arbitrage activity
Preview of Results
Arbitrage activity predicts future asset returnsFor both the underlying stocks and ETFs themselves
Arbitrage activity is associated with return reversals
ETF investors collectively mistime the market
6 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
What We DoOverview
Use ETF creation / redemption mechanism to test whethermarkets incorporate the information in arbitrage trades
ETFs provide a unique opportunity to identify demand shocksAuthorized Participants engage in arbitrage trades to correct mispricing fromrelative demand shocksDaily share changes provide an observable measure of arbitrage activity
Preview of Results
Arbitrage activity predicts future asset returnsFor both the underlying stocks and ETFs themselves
Arbitrage activity is associated with return reversals
ETF investors collectively mistime the market
6 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Motivation
What We DoOverview
Use ETF creation / redemption mechanism to test whethermarkets incorporate the information in arbitrage trades
ETFs provide a unique opportunity to identify demand shocksAuthorized Participants engage in arbitrage trades to correct mispricing fromrelative demand shocksDaily share changes provide an observable measure of arbitrage activity
Preview of Results
Arbitrage activity predicts future asset returnsFor both the underlying stocks and ETFs themselves
Arbitrage activity is associated with return reversals
ETF investors collectively mistime the market
6 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Data
ETF Sample
Monthly data for 2,196 ETFs spanning 2007 to 2016
0
500
1,000
1,500
2,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Number of ETFs in Sample
All ETFs
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Total ETF Sample AUM (billions)
All ETFs
7 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Data
ETF Sample
Monthly data for 2,196 ETFs spanning 2007 to 2016
0
500
1,000
1,500
2,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Number of ETFs in Sample
All ETFs $50M+
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Total ETF Sample AUM (billions)
All ETFs $50M+
7 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Data
ETF Sample
Monthly data for 2,196 ETFs spanning 2007 to 2016
0
500
1,000
1,500
2,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Number of ETFs in Sample
All ETFs $50M+ Mature
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Total ETF Sample AUM (billions)
All ETFs $50M+ Mature
ETFs “mature” once creation/redemption activity exceeds 50% of days
7 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Return Predictability Methodology
Sort ETFs into deciles based on net creations/redemptions over past month
Analyze differences in portfolio returns between high redemption (Decile 1)and high creation (Decile 10) ETFs
Regress monthly ETF returns on factors (raw returns, 3-factor, 4-factor and5-factor models)
Consistent results using NAV returns
Consistent results for stock-level returns using aggregated ETF creations andredemptions
8 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Return Predictability Methodology
Sort ETFs into deciles based on net creations/redemptions over past month
Analyze differences in portfolio returns between high redemption (Decile 1)and high creation (Decile 10) ETFs
Regress monthly ETF returns on factors (raw returns, 3-factor, 4-factor and5-factor models)
Consistent results using NAV returns
Consistent results for stock-level returns using aggregated ETF creations andredemptions
8 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Return Predictability Methodology
Sort ETFs into deciles based on net creations/redemptions over past month
Analyze differences in portfolio returns between high redemption (Decile 1)and high creation (Decile 10) ETFs
Regress monthly ETF returns on factors (raw returns, 3-factor, 4-factor and5-factor models)
Consistent results using NAV returns
Consistent results for stock-level returns using aggregated ETF creations andredemptions
8 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Return Predictability Methodology
Sort ETFs into deciles based on net creations/redemptions over past month
Analyze differences in portfolio returns between high redemption (Decile 1)and high creation (Decile 10) ETFs
Regress monthly ETF returns on factors (raw returns, 3-factor, 4-factor and5-factor models)
Consistent results using NAV returns
Consistent results for stock-level returns using aggregated ETF creations andredemptions
8 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Return Predictability Methodology
Sort ETFs into deciles based on net creations/redemptions over past month
Analyze differences in portfolio returns between high redemption (Decile 1)and high creation (Decile 10) ETFs
Regress monthly ETF returns on factors (raw returns, 3-factor, 4-factor and5-factor models)
Consistent results using NAV returns
Consistent results for stock-level returns using aggregated ETF creations andredemptions
8 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
ETF Arbitrage Negatively Predicts Returns
0.681** 0.712*
‐1.312***
‐0.485
‐2
‐1
0
1
2
Equal‐Weighted (1.99%***) Value‐Weighted (1.20%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns
Redemptions (Decile 1) Creations (Decile 10)
9 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
ETF Arbitrage Negatively Predicts Returns
0.681** 0.712*
‐1.312***
‐0.485
‐2
‐1
0
1
2
Equal‐Weighted (1.99%***) Value‐Weighted (1.20%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns
Redemptions (Decile 1) Creations (Decile 10)
Equal-weighted → 26.7% annualized raw return
9 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
ETF Arbitrage Negatively Predicts Returns
0.681** 0.712*
‐1.312***
‐0.485
‐2
‐1
0
1
2
Equal‐Weighted (1.99%***) Value‐Weighted (1.20%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns
Redemptions (Decile 1) Creations (Decile 10)
Value-weighted → 15.4% annualized raw return
9 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
ETF Arbitrage Negatively Predicts Returns
0.681** 0.712*
‐1.312***
‐0.485
‐2
‐1
0
1
2
Equal‐Weighted (1.99%***) Value‐Weighted (1.20%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns
Redemptions (Decile 1) Creations (Decile 10)
Return reversion suggests relative demand shocks are non-fundamental,consistent with Ben-David, Franzoni, Moussawi (Forthcoming JF)
9 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
ETF Arbitrage Negatively Predicts Returns
0.681** 0.712*
‐1.312***
‐0.485
‐2
‐1
0
1
2
Equal‐Weighted (1.99%***) Value‐Weighted (1.20%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns
Redemptions (Decile 1) Creations (Decile 10)
Similar results using factor-based alphas or NAVs
9 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Predictability Stronger in High-Activity ETFs
0.620.86**
1.04**
0.52
‐0.64‐0.79
‐2.00
‐1.00
0.00
1.00
2.00
Low Activity (0.10%) Medium Activity (1.50%***) High Activity (1.83%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns by ETF Activity Terciles
Redemptions (Decile 1) Creations (Decile 10)
10 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Predictability Stronger in High-Activity ETFs
0.620.86**
1.04**
0.52
‐0.64‐0.79
‐2.00
‐1.00
0.00
1.00
2.00
Low Activity (0.10%) Medium Activity (1.50%***) High Activity (1.83%**)
Mon
thly Return (%
)
High Redemption vs. High Creation Raw ETF Returns by ETF Activity Terciles
Redemptions (Decile 1) Creations (Decile 10)
More arbitrage activity is associated with more return predictability
10 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Results Concentrated in Levered and Broad-Market ETFs
0.54**
1.53*1.19
0.08
‐0.28
1.20
0.10
‐1.02***
‐2.80***‐2.48***
‐0.29‐0.06
0.27
‐0.25
‐4.00
‐3.00
‐2.00
‐1.00
0.00
1.00
2.00
Overall(1.56%***)
Levered(4.23%***)
Broad Market(3.67%***)
Sector‐Based(0.37%)
Bond(‐0.22%)
Commodity(0.93%)
International(0.35%)
Mon
tly Return (%
)
High Redemption vs. High Creation Raw ETF Returns by ETF Category
Redemptions (Decile 1) Creations (Decile 10)
11 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Results Concentrated in Levered and Broad-Market ETFs
0.54**
1.53*1.19
0.08
‐0.28
1.20
0.10
‐1.02***
‐2.80***‐2.48***
‐0.29‐0.06
0.27
‐0.25
‐4.00
‐3.00
‐2.00
‐1.00
0.00
1.00
2.00
Overall(1.56%***)
Levered(4.23%***)
Broad Market(3.67%***)
Sector‐Based(0.37%)
Bond(‐0.22%)
Commodity(0.93%)
International(0.35%)
Mon
tly Return (%
)
High Redemption vs. High Creation Raw ETF Returns by ETF Category
Redemptions (Decile 1) Creations (Decile 10)
Levered ETFs show the strongest predictability
11 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: ETF-Level Evidence
Results Concentrated in Levered and Broad-Market ETFs
0.54**
1.53*1.19
0.08
‐0.28
1.20
0.10
‐1.02***
‐2.80***‐2.48***
‐0.29‐0.06
0.27
‐0.25
‐4.00
‐3.00
‐2.00
‐1.00
0.00
1.00
2.00
Overall(1.56%***)
Levered(4.23%***)
Broad Market(3.67%***)
Sector‐Based(0.37%)
Bond(‐0.22%)
Commodity(0.93%)
International(0.35%)
Mon
tly Return (%
)
High Redemption vs. High Creation Raw ETF Returns by ETF Category
Redemptions (Decile 1) Creations (Decile 10)
Broad market ETFs, not niche ETFs, drive our results
11 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
What Does This Cost Investors?
Our results suggest ETF investors collectively mistime market
ETF creations → lower future ETF performance
ETF redemptions → higher future ETF performance
Implication: investors consistently overpay to gain ETF exposure
Individual cost depends on frequency of trade
We consider a representative investor who re-balances according tocreations/redemptions
12 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
What Does This Cost Investors?
Our results suggest ETF investors collectively mistime market
ETF creations → lower future ETF performance
ETF redemptions → higher future ETF performance
Implication: investors consistently overpay to gain ETF exposure
Individual cost depends on frequency of trade
We consider a representative investor who re-balances according tocreations/redemptions
12 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
What Does This Cost Investors?
Our results suggest ETF investors collectively mistime market
ETF creations → lower future ETF performance
ETF redemptions → higher future ETF performance
Implication: investors consistently overpay to gain ETF exposure
Individual cost depends on frequency of trade
We consider a representative investor who re-balances according tocreations/redemptions
12 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
What Does This Cost Investors?
Our results suggest ETF investors collectively mistime market
ETF creations → lower future ETF performance
ETF redemptions → higher future ETF performance
Implication: investors consistently overpay to gain ETF exposure
Individual cost depends on frequency of trade
We consider a representative investor who re-balances according tocreations/redemptions
12 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Time-Series Methodology
Standard time-series analysis assumes fixed quantities of shares
ETF time-series analysis must account for creations and redemptions
We generate share-growth-adjusted (i.e. asset-weighted) returns to accountfor total capital invested in ETFs
Effective fees capture difference between actual and asset-weighted returns
We randomize ETF flows using block-bootstrap Monte Carlo methods to:
Generate test statistics (p-values based on 1,000,000 simulations)
Control for growth of ETF industry over time
13 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Time-Series Methodology
Standard time-series analysis assumes fixed quantities of shares
ETF time-series analysis must account for creations and redemptions
We generate share-growth-adjusted (i.e. asset-weighted) returns to accountfor total capital invested in ETFs
Effective fees capture difference between actual and asset-weighted returns
We randomize ETF flows using block-bootstrap Monte Carlo methods to:
Generate test statistics (p-values based on 1,000,000 simulations)
Control for growth of ETF industry over time
13 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Time-Series Methodology
Standard time-series analysis assumes fixed quantities of shares
ETF time-series analysis must account for creations and redemptions
We generate share-growth-adjusted (i.e. asset-weighted) returns to accountfor total capital invested in ETFs
Effective fees capture difference between actual and asset-weighted returns
We randomize ETF flows using block-bootstrap Monte Carlo methods to:
Generate test statistics (p-values based on 1,000,000 simulations)
Control for growth of ETF industry over time
13 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Time-Series Methodology
Standard time-series analysis assumes fixed quantities of shares
ETF time-series analysis must account for creations and redemptions
We generate share-growth-adjusted (i.e. asset-weighted) returns to accountfor total capital invested in ETFs
Effective fees capture difference between actual and asset-weighted returns
We randomize ETF flows using block-bootstrap Monte Carlo methods to:
Generate test statistics (p-values based on 1,000,000 simulations)
Control for growth of ETF industry over time
13 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Time-Series Methodology
Standard time-series analysis assumes fixed quantities of shares
ETF time-series analysis must account for creations and redemptions
We generate share-growth-adjusted (i.e. asset-weighted) returns to accountfor total capital invested in ETFs
Effective fees capture difference between actual and asset-weighted returns
We randomize ETF flows using block-bootstrap Monte Carlo methods to:
Generate test statistics (p-values based on 1,000,000 simulations)
Control for growth of ETF industry over time
13 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Effective Fees Are More Negative Than Positive
0%
5%
10%
15%
20%
25%
30%Pe
rcen
t of O
bservatio
ns
P‐Values
Distribution of Effective Fee P‐Values
Equal‐Weights Value‐Weights Expected Distribution
14 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Effective Fees Are More Negative Than Positive
0%
5%
10%
15%
20%
25%
30%Pe
rcen
t of O
bservatio
ns
P‐Values
Distribution of Effective Fee P‐Values
Equal‐Weights Value‐Weights Expected Distribution
Equal-weighted → 12% < 0.05 p-value threshold
14 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Effective Fees Are More Negative Than Positive
0%
5%
10%
15%
20%
25%
30%Pe
rcen
t of O
bservatio
ns
P‐Values
Distribution of Effective Fee P‐Values
Equal‐Weights Value‐Weights Expected Distribution
Value-weighted → 26% < 0.05 p-value threshold
14 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Empirical Analysis: Time Series Evidence
Negative Effective Fee Examples: SPY & Total ETF AUM
SPY (largest ETF, replicates S&P500):
Actual annual return (2007–2016): 6.89%
Average simulated share-growth-adjusted annual return: 6.92%
Realized share-growth-adjusted annual return: 5.44%
Annualized Effective Fee: 1.48%
Total ETF AUM (Aggregated)
Annualized effective fee (2007–2016): 0.33%
Annualized effective fee (2007–2011): 0.55%
Annualized effective fee (2012–2016): 0.07%
0.07% on $2.3 trillion AUM → $1.6 billion of underperformance in 2016
15 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Conclusion
Take Aways
1 ETF arbitrage activity negatively predicts future returns
2 Observable, non-fundamental demand shocks are not quickly offset bymarket participants
3 Information conveyed by arbitrage trades is not fully incorporated intoprices
16 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Conclusion
Take Aways
1 ETF arbitrage activity negatively predicts future returns
2 Observable, non-fundamental demand shocks are not quickly offset bymarket participants
3 Information conveyed by arbitrage trades is not fully incorporated intoprices
16 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
Conclusion
Take Aways
1 ETF arbitrage activity negatively predicts future returns
2 Observable, non-fundamental demand shocks are not quickly offset bymarket participants
3 Information conveyed by arbitrage trades is not fully incorporated intoprices
16 / 16ETF Arbitrage and Return PredictabilityBrown, Davies and Ringgenberg
N
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