A new paper by Ilias Filippou and two other scholars looks at ETF arbitrage. This is a trading strategy that plays off of discrepancies between the value of the exchange-traded funds on the one hand and the value of their underlying stocks on the other.
ETF arb is not new, but Filippou, assistant professor of financial economics at Warwick Business School, with Arie Gozluklu and Hari Rozental, bring a new perspective to it, because they show how the practice works to increase the correlation of developments in other economies with those of the US. Shocks in the US “propagate to local economies,” especially to their equities, through ETF price discovery. Gozluklu is an associate professor of finance at Warwick and Rozental is a graduate student pursuing a doctorate.
Order Imbalances
A key empirical point in their study is that international ETF market participants trade on the basis of what is happening in the US, not predominantly on the basis of what is happening in the other countries where one finds the underlying assets. Filippou et al. test this point by computing the order imbalances of retail investors in 41 countries. Retail investors are especially significant here because as the authors concisely observe, “ETFs are designed for retail investors.” There are several reasons why, for such an investor based in the US, an international ETF may be the best way to achieve some geographical diversification. At any rate, the ETF order imbalances these authors study correspond strongly to the CBOE Volatility Index, US VIX, indicating that what US VIX measures is what drives the international investment decisions.
This strong correlation, Filippou et al. write, is robust “to different volatility regimes and is consistent across different types of investors.”
Degrees of Sophistication
ETF fund flows are much more sensitive to global risk factors than mutual funds are, and much less sensitive to local risk factors. Other scholars, making the same observation, have contended that it shows that investors in ETFs are less sophisticated than are mutual fund investors. On that hypothesis, the unsophisticated investors only keep track of the biggest headlines, which are headlines about global matters. More sophisticated investors, who may be in mutual funds, get much more granular about what is happening in the other countries involved.
But the authors don’t believe in that hypothesis. They contend that the extra salience of US-related risks and of global political uncertainty are facts true of all investor types, across degrees of sophistication.
Another take on the subject: perhaps what is going on in the ETF world is what some call a “wake-up” effect. Investors believe (and rightly) that a crisis that begins in one country can have bearing on the real value of assets in other countries. Given the central importance of the US exchanges, US crises serve as the alarm bell.
This wake-up hypothesis belongs to a body of research that dates back more than 20 years, to a paper by Bruno Solnik, Cyril Boucrelle, and Yann Le Fur in the Financial Analysts’ Journal in 1996. Solnik, Boucrelle, and Le Fur were all affiliated with the Groupe HEC School of Management in France.
Filippou et al. employ the insights of Solnik et al. and of all the others who have worked in that line to put together the following model: economic shock events in the US cause changes in ETF valuations, whether the underlyings of those ETFs are US-based or not; the changes in international ETF valuations then create or expand a discount or premium with regard to the local underlying assets; that in turn encourages arbitrageurs, and finally; those arbs create cross-country correlation. This model helps explain why “even emerging countries with low integration are still significantly affected by the U.S. stock market.”
A Final Thought
In working through this model, the authors also look for the effects of US-based political uncertainty on investor decisions. They find in general that ETF investors tend to treat US economic uncertainty as a different creature from political uncertainty. Economic uncertainty is treated as a proxy for global risk so, as noted, it can cause sell-offs in international ETFs. US political uncertainty, though, is seen as US-specific. It might induce purchases in international ETFs in pursuit of geographical diversification.