ETF Arbitrage and International Correlation

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 demonstrate that the ETF arbitrage 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, limiting the benefits from international diversification. Staggered introduction of country ETFs increases the return correlations between underlying foreign and U.S. market indices. We find that countries with stronger ETF price discovery and lower limits to arbitrage have a higher comovement with the U.S. market lending further support for the proposed arbitrage mechanism.