How ETF Trading Hurts Active Managers & Hedge Funds

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The Rise of ETF Trading

Investments in ETFs have increased dramatically over the past decade relative to investments in active funds. The assets managed by ETFs have increased from $600 billion in 2007 to over $4 trillion today. With the increase in assets under management, investors have become increasingly concerned about how ETFs may distort prices and impair a manager’s ability to drive alpha.

How ETF Trading Impacts Stocks & May Hurt Active & Hedge Fund Managers

Chief among investors’ concerns has been the possibility that stocks will move more in line with the ETFs that hold them rather than the underlying fundamentals.  Will continued flows to ETFs and passive instruments equate the strong performance of individual companies and their management with that of middling performances?

One measure of decreased sensitivity to fundamentals would be a stock’s failure to respond to earnings related news. Our research confirms this. Stocks with a high degree of corresponding ETF trading activity are less likely to react to fundamental news on earnings days.

How Active & Hedge Fund Managers Should Incorporate ETF Trading into their Strategy

Stocks that have more exposure to ETF related trading volume become less sensitive to earnings-related news. If an individual stock detaches from or otherwise becomes less sensitive to its underlying fundamentals, it necessarily presents less stock-specific risk. As one might say, they may not be trading according to their fundamentals. In the case of heavy, corresponding ETF volume, the affected stocks have been shown to trade more in line with the supply and demand for the ETFs that hold the stock than how the company is performing. Portfolio managers looking for a fundamental story in a stock would be wise to understand and possibly minimize their exposure to these positions.

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