In this research paper titled “The Returns and Limits to Relative-Value ETF Arbitrage,” authored by Philipp Doering from Ruhr University of Bochum’s Department of Finance and Banking, the focus is on investigating the relative price gaps that occasionally emerge between pairs of nearly identical Exchange-Traded Funds (ETFs) listed on US exchanges.
While prices generally move in tandem, at times, they deviate from parity by significant amounts. Examining the period from 2010 to 2016, a straightforward pairs trading strategy yielded abnormal returns of up to 1.8 percent per year, net of fees. Intriguingly, these price gaps cannot be attributed to fundamental differences in liquidity, replication methodologies, or security lending activities. Instead, they appear linked to both proxies for cross-sectional and time-varying limits to arbitrage.
Notably, prices tend to diverge after sequences of days marked by abnormally low liquidity in both the relatively over- and underpriced funds. This research thus sheds light on the dynamics of relative-value ETF arbitrage, offering insights into the potential returns and the inherent limits within this trading strategy.
Abstract Of Paper
This paper studies relative price gaps between pairs of nearly identical Exchange-Traded Funds (ETFs) listed on US exchanges. Prices usually move in lockstep, but sometimes diverge from parity by larger amounts. Over the period 2010-2016, a simple pairs trading strategy produced abnormal returns of up to 1.8 percent per year net of fees. Price gaps cannot be justified by fundamental differences in liquidity, replication methodologies, or security lending activities, but are related to both proxies for cross-sectional and time-varying limits to arbitrage. Prices typically diverge following a sequence of days with abnormally low liquidity in both the relatively over- and underpriced fund.
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Author
Philipp Doering
Ruhr University of Bochum – Department of Finance and Banking
Conclusion
In this exploration by Philipp Doering, the focus lies on the returns and constraints associated with relative-value ETF arbitrage, specifically studying price gaps between nearly identical Exchange-Traded Funds (ETFs) listed on US exchanges. While prices typically move in tandem, occasional divergences from parity are observed, leading to the investigation of abnormal returns generated by a simple pairs trading strategy from 2010 to 2016, amounting to up to 1.8 percent per year net of fees.
The study meticulously rules out fundamental differences in liquidity, replication methodologies, or security lending activities as justifications for these price gaps. Instead, it identifies a correlation with proxies for cross-sectional and time-varying limits to arbitrage. Interestingly, the observed price divergences tend to follow periods of abnormally low liquidity in both the relatively over- and underpriced funds.
In conclusion, this research unravels the intriguing dynamics of relative-value ETF arbitrage, revealing both the returns it can yield and the constraints it faces. The findings present a nuanced understanding of the factors influencing price gaps, providing valuable insights for practitioners seeking to capitalize on arbitrage opportunities within the realm of Exchange-Traded Funds.
FAQ:
– What is the main focus of the research paper “The Returns and Limits to Relative-Value ETF Arbitrage” by Philipp Doering?
The research paper examines relative price gaps that emerge between pairs of nearly identical Exchange-Traded Funds (ETFs) listed on US exchanges. These ETFs are expected to move in tandem, but at times, their prices significantly deviate from parity.
– What are the key findings of the study regarding the potential for profitable trading strategies involving relative-value ETF arbitrage?
The study reveals that a straightforward pairs trading strategy can generate abnormal returns of up to 1.8 percent annually, net of fees, over the period of 2010-2016. Importantly, these price gaps cannot be readily explained by fundamental differences in liquidity, replication methodologies, or security lending activities. Instead, they are associated with both cross-sectional and time-varying limits to arbitrage.
– What factors contribute to the price divergence between pairs of ETFs, as highlighted in the research?
The price divergence between pairs of ETFs tends to occur following sequences of days characterized by abnormally low liquidity in both the relatively overpriced and underpriced ETF. These liquidity-driven dynamics are linked to cross-sectional and time-varying limits to arbitrage, creating opportunities for profitable trading strategies.
