Index Arbitrage Strategy Works Well with Fast-Growing ETFs

Thor McLaughlin detailed an easy to exploit ETF arbitrage opportunity in his paper – Eyes Wide Shut: Exchange Traded Funds, Index Arbitrage, And The Need for Change –  The opportunity lies in the fundamental mechanism of those ETFs tracking indexes, of which the criteria for enlisting and delisting is clear and transparent, and usually required preannouncment, causing arbitragers to buy in the former securities and sell out the latter ones ahead of the mass ETF or associated index fund investors. The profits are gained upon the loss of these fund investors.

As the ETF market is growing bigger and bigger, more securities with trillions of dollars are tied to ETFs. this arbitrage is working more effective at the cost of mass investors. The author proclaims that index providers and the SEC take a proactive role in decreasing the possibility of such index arbitrage, but hardly did he come up with a concrete, executable plan to realize this goal.

Therefore, there will be a lot more arbitragers entering this market. We can even create such an ETF to monitor and screen out these two types of securities periodically for investors to exploit this loophole opportunity at the cost of other investors who are not aware of this phenomena yet.

It won’t take much time for the whole market to price in this activity and hence close out the wide profit margin. However, what worth a further thinking upon this index arbitrage is the consequence. Apparently, the up and down of stock prices driven purely by the eligibility of some largely tracked indexes are not reflecting the fundamental side of their real value. After a period, their prices should revert to the base level corresponding to their true, intrinsic value. So I see the fluctuations caused by ETF enlisting/delisting, further dramatized by “index arbitraging” is not beneficial to the market but creating unnecessary volatility and transaction frictions.

Documented in his paper early in 2012 ETFs, Arbitrage, and Shock Propagation – 
Itzhak Ben-David investors et al pointed out the potential issue of ETF products in increasing non-fundamental volatility and in propagating shocks across markets, especially in association with high-frequency trading. In 2015, he further elaborated his observation and analysis of ETF versus market volatility in this paper – Do ETFs Increase Volatility?  He found that stocks with higher ETF ownership display significantly higher volatility.

It’s interesting to see the ownership percentage in S&P 500 and Russell 3000 over the course from 2000 to 2012, as is exhibited/cited below:

etf ownership.JPG

 

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