Market Efficiency Boosted by Active ETFs’ Short-Selling Feature
Tougher Penalties for Poor Performance
New research reveals that active ETFs play a crucial role in maintaining market efficiency by weeding out underperforming managers and discouraging low-quality ones from entering the industry. A recent study, “ETFs as a disciplinary device,” co-authored by a Bank of International Settlements economist and two Hong Kong University of Science and Technology researchers, sheds light on the significant impact of active ETF flows on manager performance.
Short Sellers: Effective Identifiers of Underperforming Managers
The study finds that active ETF flows are five times more sensitive to performance than mutual funds, largely due to the ability of investors to establish short positions. This leads to outflows from underperforming funds, ultimately forcing poor managers out of the industry. Short sellers, in particular, have been found to be skilled at identifying underperforming managers, with high levels of short selling serving as a statistically significant predictor of negative alpha.
Superior Pool of Managers
As a result, active ETF managers face much tougher penalties for poor performance and are more likely to be forced out of the industry. This, in turn, creates a superior pool of managers compared to active mutual funds. The study’s authors note that top-performing managers are more likely to manage both active ETFs and mutual funds, as they are confident in their abilities and less afraid of being forced out.
Active ETF Industry Poised for Dominance
In the US, active management ETFs are gaining traction, with over 1,570 active ETFs traded on the markets, boasting total assets under management of $754.34 billion, and an average expense ratio of 0.71%. This growth is expected to continue, with active ETFs likely to dominate the industry in the coming years.
A Shift Towards Efficient Markets
The short-selling feature of active ETFs has been instrumental in promoting market efficiency by removing poorly performing managers and deterring low-quality ones from entering the industry. As the active ETF industry continues to grow, it is likely to lead to a more efficient market, where only the best managers thrive.
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