ETF Rebalancing, Hedge Fund Trades, and Capital Market
48 Pages Posted: 13 Jan 2023 Last revised: 29 Jan 2023
Date Written: January 1, 2023
We study the interaction between ETF rebalancing and hedge fund “front-running” trades and its implications for the capital market. First, we document that ETF rebalancing has a strong negative relation with future stock returns. Second, we observe that hedge funds gradually increase (decrease) their net arbitrage positions before ETF rebalancing. Strikingly, the “front-running” stocks bought by hedge funds significantly outperform stocks not subject to hedge funds front-running by 0.86% (with a t-statistic of 3.86) before the month of ETF rebalancing. Our findings raise the question of the potential cost of ETFs rebalancing due to their embedded transparency and predictability, which creates anticipatory arbitrage trading by hedge funds.
Keywords: ETF Rebalancing, Hedge Funds, Arbitrage Trades, Stock Returns
JEL Classification: G10, G12, G14, G23
Suggested Citation: Suggested Citation