ETFs as a disciplinary device

Summary

Focus

We investigate the role of actively managed exchange-traded funds (AETFs) as a disciplinary mechanism in the asset management industry, which distinguishes AETFs from traditional mutual funds and passive ETFs. We explore how the unique short-selling feature of AETFs enables investors to penalise underperforming fund managers, thereby enhancing market efficiency. We also examine the implications of AETFs for fund flows, managerial turnover, investment strategies and the price informativeness of underlying stocks.

Contribution

We highlight the short-selling feature of AETFs as a market-based disciplinary tool, a previously unexplored aspect in the literature on asset management. While previous studies have focused on the tax efficiency, liquidity and transparency of ETFs, we extend the understanding of AETFs by demonstrating their role in improving the efficiency of the fund management industry. Our paper also complements existing research on short-selling and market efficiency by showing how short-selling can discipline active fund managers, thereby bridging gaps in the literature on active ETFs and their impact on managerial performance and market dynamics.

Findings

We find that AETFs exhibit over five times greater flow-performance sensitivity than mutual funds, making them more effective at penalising underperforming managers. Investors actively short-sell AETF shares when poor-performing managers join, leading to higher outflows and increasing the likelihood that these managers will exit the industry. This process enhances the overall quality of fund management by retaining high-performing managers. Additionally, AETFs are associated with improved price informativeness of their underlying stocks, and AETFs exhibit a higher propensity for risk taking, favouring momentum and stocks with higher idiosyncratic risk.

Abstract

We document a novel feature of active exchange-traded funds (AETFs): they serve as a disciplinary tool for investors to remove underperforming portfolio managers. Unlike mutual fund shares, ETF shares can be shorted, which enables investors to bet against manager performance. We show that AETFs exhibit over five times greater flow-performance sensitivity than mutual funds, indicating that AETF managers face harsher penalties for poor performance. When an underperforming manager joins an AETF, investors respond by shorting more shares of the fund. Consequently, this manager is more likely to exit the fund management industry, thereby enhancing overall sector efficiency and allowing more high-performing managers to remain. Moreover, the stocks held within AETFs exhibit improved price informativeness. We also find that AETF managers outperform both mutual fund and passive fund managers. In summary, the short-selling feature of AETFs serves as a disciplining device and enhances market efficiency by facilitating the removal of underperforming managers.

JEL classification: G10, G11, G12, G20, G23

Keywords: ETF, mutual funds, performance, flow, active fund management