ETF Rebalancing, Hedge Fund Trades, and Capital Market

Abstract

We examine the interaction between ETF rebalancing and hedge funds (HFs) trades. Our analysis reveals that the transparency and predictability inherent in ETF rebalancing provide opportunities for anticipatory arbitrage trading by HFs, who gradually adjust their long and short positions ahead of ETF rebalancing. Using the quasi-natural experiment of the index rebalancing postponement in March 2020, we establish causal evidence of HF’s anticipatory trading. Furthermore, we find supportive evidence by analyzing HFs’ option positions. While ETF rebalancing is associated with strong price distortions of the underlying securities, we demonstrate that HFs’ anticipatory trading exaggerates the price impact of non-fundamental demand, highlighting the hidden costs of ETF rebalancing.

Keywords: ETF Rebalancing, Hedge Funds, Anticipatory Trades

JEL Classification: G10, G12, G23, G11