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In Index arbitrage, people usually buy(sell) a future against the basket of stocks that form the index.

Why they don't just use the index etf like SPY instead of buying individual stocks? Is it not better to buy the ETF as opposed to buying the individual stocks?

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There are many kinds of index arbitrage, but I will stick to your example. If you are buying the future and selling the underlying basket (or the opposite), either you are arbitraging future mispricing versus fair value or you are taking a position in dividends, as the future does not provide dividends. Holding a future and selling the underlying is effectively being short the expected dividends.

If you do the same with an ETF, you are not taking any position on the dividends, as the ETF receives (and usually reinvest) dividends. Basically what you will arbitrage is potential mispricing between the ETF units versus the basket. But these mispricings are very difficult to catch, as they tend to be very small, and the costs of trading are usually higher than the spread you are trying to arbitrage.

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