ETF arbitrage and international diversification

Ilias Filippou, Arie Gozluklu and Hari Rozental

Journal of Banking & Finance, 2024, vol. 168, issue C

Abstract: We show that investment decisions of country ETF market participants measured by ETF market order imbalances are driven by global shocks rather than local risks. We argue that the ETF price discovery mechanism is one of the key channels through which global shocks propagate to local economies, leading to increased return correlation with the U.S. market and limiting the benefits of international diversification. ETF order imbalance is predictive of the underlying MSCI index returns. The staggered introduction of country ETFs alters return correlations between underlying foreign and U.S. market indices. We find that countries with stronger ETF price discovery have higher comovement with the U.S. market lending further support for the proposed mechanism.

Keywords: ETFs; Equity market correlation; Limits to arbitrage; VIX shocks (search for similar items in EconPapers)
JEL-codes: G11 G15 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:168:y:2024:i:c:s0378426624001882

DOI: 10.1016/j.jbankfin.2024.107274

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