Does the Tail Wag the Dog? Evidence from Fund Flow to VIX ETFs and ETNs

Abstract

Modern derivatives pricing models develop pricing relationships from the principle of no-arbitrage, assuming that if an arbitrage opportunity were to arise in the market, it would be immediately eliminated by active arbitrageurs. With this assumption, the supply curve for the derivative security is infinitely elastic at the model price, so that effects of fluctuation in supply and demand from non-arbitrageurs are suppressed. In particular, flows of funds into and out of mutual funds and ETFs should not affect market prices for the underlying securities. This article explores whether that assumption holds in the real world for ETFs based on the VIX volatility index, and finds that it doesn’t. Examining 13 volatility funds separated into four groups according to whether the focus is on nearby or longer horizons and whether volatility exposure is long or short, the authors show that fund flows respond to observed market volatility, flowing into long (short) exposure funds when the market is calm (volatile). Moreover, the VIX responds to fund flows, rising (falling) when money is flowing into long (short) exposure funds. But the evidence shows that this effect is no stronger, i.e., not unusually destabilizing, in periods of high volatility.