ETF Arbitrage and International Diversification

We show that investment decisions of ETF market participants when trading country ETFs are mostly driven by shocks to U.S. fundamentals, rather than local risks. Investors react only to negative news about local economies. When U.S. economic uncertainty increases, investors switch to Cash ETFs. We demonstrate that ETF arbitrage mechanism is one of the key channels through which U.S. shocks propagate to local economies leading to increased return correlation with the U.S. market, limiting the benefits from international diversification. We find that countries with stronger ETF price discovery and lower limits to arbitrage have a higher comovement with the U.S. market.