Innovation and Informed Trading: Evidence from Industry ETFs

Abstract

We empirically examine the impact of industry exchange traded funds (IETF) on informed trading and market efficiency. We find short interest in the IETF positively predicts the IETF return and the earnings performance of its member stocks. We also find IETF short interest spikes with hedge fund holdings on the member stock before positive earnings surprises, reflecting the “long-the-stock/short-the-IETF” strategy. This pattern is stronger among high industry-risk-exposure stocks. We conduct difference-in-difference analysis on the ETF-inception event and find IETFs reduce the post-earnings-announcement-drift more among high industry-risk-exposure stocks, indicating that IETFs improve market efficiency. We also demonstrate predictable return effects arising from the hedging use of industry ETFs.

Keywords: ETF, hedge funds, short interest, market efficiency, financial innovation

JEL Classification: G14, G12