Smart Money Flows Into ETFs and Investor Sentiment

Abstract

ETFs attract a larger proportion of institutional investors than do the underlying markets. The price of an ETF will deviate from the price of the underlying, if institutional investors are less prone to investor sentiment-driven mispricing, than are retail investors. We employ a unique identification strategy to differentiate between the response of liquidity traders, long-term and short-term arbitrageurs to sentiment measures. Liquidity traders respond positively to sentiment, which results in weaker returns in the following 3- to 6-month period. Long-term arbitrageurs who go long the ETF, and short the underlying asset benefit from this mid-term return reversal. Finally, short-term arbitrageurs respond negatively to the Baker and Wurgler (2006) sentiment measure. Their actions are profitable in the long-run as ETFs that experience higher short-term arbitrage activity experience weaker reversals.

Keywords: Fund flows, Investor sentiment, market efficiency, mental accounting bias, ETFs, behavioral finance

JEL Classification: G10, G11, G12, G14, G23, G41