Predictable ETF Order Flows and Market Quality

Abstract

Institutional order flow can often be predicted. Examples include trades by index funds when stocks are added to or deleted from indexes; the rebalancing trades of rules-based ETFs, including leveraged and inverse ETFs; rebalancing to maintain target asset weights; rebalancing to maintain option hedges; and roll outs of expiring futures contracts. Some authors have highlighted the destabilizing effects on market quality related to predictable order flow. The goal of this article is to provide a deeper analysis of the existing infrastructure and the issues that arise from the execution of predictable institutional orders. Considering the roles of information and competition, predictable orders should in long run equilibrium have minimal effects on prices, because they are most often not motivated by fundamental information, they attract natural counterparties, and they benefit from additional liquidity supply.