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ETF arbitrage and international diversification

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  • Filippou, Ilias
  • Gozluklu, Arie
  • Rozental, Hari

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.

Suggested Citation

  • Filippou, Ilias & Gozluklu, Arie & Rozental, Hari, 2024. "ETF arbitrage and international diversification," Journal of Banking & Finance, Elsevier, vol. 168(C).
    • Handle: RePEc:eee:jbfina:v:168:y:2024:i:c:s0378426624001882
    DOI: 10.1016/j.jbankfin.2024.107274
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    More about this item

    Keywords

    ETFs; Equity market correlation; Limits to arbitrage; VIX shocks;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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